N.G Mankiw, R.reis, J.wolfers Disagreement About Inflation Expectations

This PDF is a selection from a published volume from
the National Bureau of Economic Research
Volume Title: NBER Macroeconomics Annual 2003,

Volume 18
Volume Author/Editor: Mark Gertler and Kenneth
Rogoff, editors
Volume Publisher: The MIT Press
Volume ISBN: 0-262-07253-X
Volume URL: http://www.nber.org/books/gert04-1
Conference Date: April 4-5, 2003
Publication Date: July 2004
Title: Disagreement about Inflation Expectations

Author: N. Gregory Mankiw, Ricardo Reis, Justin
Wolfers
URL: http://www.nber.org/chapters/c11444
N. Gregory Mankiw, Ricardo Reis,

and Justin Wolfers
HARVARD UNIVERSITY AND NBER; HARVARD UNIVERSITY; AND
STANFORD UNIVERSITY AND NBER
Disagreement About Inflation

Expectations
1. Introduction
At least since Milton Friedman's renowned presidential address to the
American Economic Association in 1968, expected inflation has played a
central role in the analysis of monetary policy and the business cycle.
How much expectations matter, whether they are adaptive or rational,
how quickly they respond to changes in the policy regime, and many
related issues have generated heated debate and numerous studies. Yet
throughout this time, one obvious fact is routinely ignored: not everyone
has the same expectations.
This oversight is probably explained by the fact that, in much standard
theory, there is no room for disagreement. In many (though not all) textbook macroeconomic models, people share a common information set
and form expectations conditional on that information. That is, we often
assume that everyone has the same expectations because our models say
that they should.
The data easily reject this assumption. Anyone who has looked at survey data on expectations, either those of the general public or those of
professional forecasters, can attest to the fact that disagreement is substantial. For example, as of December 2002, the interquartile range of
inflation expectations for 2003 among economists goes from V/2% to 2Vi%.
We would like to thank Richard Curtin and Guhan Venkatu for help with data sources, and
Simon Gilchrist, Robert King, and John Williams for their comments. Doug Geyser and
Cameron Shelton provided research assistance. Ricardo Reis is grateful to the Fundacao
Ciencia e Tecnologia, Praxis XXI, for financial support.
210 MANKIW, REIS, & WOLFERS

Among the general public, the interquartile range of expected inflation
goes from 0% to 5%.
This paper takes as its starting point the notion that this disagreement
about expectations is itself an interesting variable for students of monetary policy and the business cycle. We document the extent of this
disagreement and show that it varies over time. More important,
disagreement about expected inflation moves together with the other
aggregate variables that are more commonly of interest to economists.
This fact raises the possibility that disagreement may be a key to macroeconomic dynamics.
A macroeconomic model that has disagreement at its heart is the stickyinformation model proposed recently by Mankiw and Reis (2002). In this
model, economic agents update their expectations only periodically
because of the costs of collecting and processing information. We investigate whether this model is capable of predicting the extent of disagreement that we observe in the survey data, as well as its evolution over
time.
The paper is organized as follows. Section 2 discusses the survey data
on expected inflation that will form the heart of this paper. Section 3 offers
a brief and selective summary of what is known from previous studies of
survey measures of expected inflation, replicating the main findings.
Section 4 presents an exploratory analysis of the data on disagreement,
documenting its empirical relationship to other macroeconomic variables.
Section 5 considers what economic theories of inflation and the business
cycle might say about the extent of disagreement. It formally tests the predictions of one such theorythe sticky-information model of Mankiw
and Reis (2002). Section 6 compares theory and evidence from the Volcker
disinflation. Section 7 concludes.
2. Inflation Expectations
Most macroeconomic models argue that inflation expectations are a crucial factor in the inflation process. Yet the nature of these expectationsin
the sense of precisely stating whose expectations, over which prices, and
over what horizonis not always discussed with precision. These are crucial issues for measurement.
The expectations of wage- and price-setters are probably the most relevant. Yet it is not clear just who these people are. As such, we analyze data
from three sources. The Michigan Survey of Consumer Attitudes and
Behavior surveys a cross section of the population about their expectations
over the next year. The Livingston Survey and the Survey of Professional
Forecasters (SPF) covers more sophisticated analystseconomists working
Disagreement About Inflation Expectations 211
Table 1 SURVEYS OF INFLATION EXPECTATIONS

Survey of professional
forecasters
Michigan survey
Livingston survey
Survey
population
Cross section of
the general
public
Academic,
business, finance,
market, and
labor economists
Market
economists
Survey
organization
Survey Research
Center, University
of Michigan
Originally Joseph
Livingston, an
economic journalist;
currently the
Philadelphia Fed
Originally
ASA/NBER;
currently the
Philadelphia Fed
Average
number of
respondents
Roughly 1000-3000
per quarter to 1977,
then 500-700 per
month to present
48 per survey
(varies from
14-63)
34 per survey
(varies from 9-83)
Starting date
Qualitative
questions: 1946
Ql1; quantitative
responses: January
1978
1946, first half

(but the early data
is unreliable)1
GDP deflator: 1968,
Periodicity
Most quarters from

1947 Ql to 1977
Q4; every month
from January 1978
Semi-annual
Quarterly
Inflation
expectation
Expected change
in prices over the
next 12 months
Consumer Price
Index (this quarter,
in 2 quarters, in
4 quarters)
GDP deflator level,

quarterly CPI level
(6 quarters)
Q4;
CPI inflation:
1981, Q3
1. Our quantitative work focuses on the period from 1954 onward.
in industry and professional forecasters, respectively. Table 1 provides

some basic details about the structure of these three surveys.1
Although we have three sources of inflation expectations data, throughout this paper we will focus on four, and occasionally five, series. Most
papers analyzing the Michigan data cover only the period since 1978, during which these data have been collected monthly (on a relatively consistent basis), and respondents were asked to state their precise quantitative
1. For more details about the Michigan Survey, the Livingston Survey and the SPF, see
Curtin (1996), Croushore (1997), and Croushore (1993), respectively.

Figure 1 MEDIAN INFLATION EXPECTATIONS AND ACTUAL INFLATION
Michigan Survey
Michigan Experimental
Livingston
SPF: GDP Deflator
15-1
10-
0-
15-
1950
1960
1970
1980
1990
2000 1950
1960
1970
1980
1990
2000
Year: Actual and forecast shown at endpoint of horizon

Year-ended inflation rate
Expected Inflation
inflation expectations. However, the Michigan Survey of Consumer

Attitudes and Behaviors has been conducted quarterly since 1946,
although for the first 20 years respondents were asked only whether they
expected prices to rise, fall, or stay the same. We have put substantial
effort into constructing a consistent quarterly time series for the central
tendency and dispersion of inflation expectations through time since
1948. We construct these data by assuming that discrete responses to
whether prices are expected to rise, remain the same, or fall over the next
year reflect underlying continuous expectations drawn from a normal distribution, with a possibly time-varying mean and standard deviation.2 We
will refer to these constructed data as the Michigan experimental series.
Our analysis of the Survey of Professional Forecasters will occasionally
switch between our preferred series, which is the longer time series of
forecasts focusing on the gross domestic product (GDP) deflator (starting
in 1968, Q4), and the shorter consumer price index (CPI) series (which
begins in 1981, Q3).
Figure 1 graphs our inflation expectations data. The horizontal axis
refers to expectations at the endpoint of the relevant forecast horizon
2. Construction of this experimental series is detailed in the appendix, and we have published
these data online at www.stanford.edu/people/jwolfers (updated January 13, 2004).
rather than at the time the forecast was made. Two striking features
emerge from these plots. First, each series yields relatively accurate inflation forecasts. And second, despite the different populations being surveyed, they all tell a somewhat similar story.
By simple measures of forecast accuracy, all three surveys appear to be
quite useful. Table 2 shows two common measures of forecast accuracy:
the square root of the average squared error (RMSE) and the mean
absolute error (MAE). In each case we report the accuracy of the median
expectation in each survey, both over their maximal samples and for a
common sample (September 1982-March 2002).
Panel A of the table suggests that inflation expectations are relatively
accurate. As the group making the forecast becomes increasingly sophisticated, forecast accuracy appears to improve. However, Panel B suggests that
these differences across groups largely reflect the different periods over
which each survey has been conducted. For the common sample that all five
measures have been available, they are all approximately equally accurate.
Of course, these results reflect the fact that these surveys have a similar
central tendency, and this fact reveals as much as it hides. Figure 2 presents simple histograms of expected inflation for the coming year as of
December 2002.
Here, the differences among these populations become starker. The left
panel pools responses from the two surveys of economists and shows
some agreement on expectations, with most respondents expecting inflation in the VA to 3% range. The survey of consumers reveals substantially
greater disagreement. The interquartile range of consumer expectations
stretches from 0 to 5%, and this distribution shows quite long tails, with
5% of the population expecting deflation, while 10% expect inflation of at
Table 2 INFLATION FORECAST ERRORS
Michigan
Michigan
experimental
Livingston
SPF-GDP
deflator
SPF-CPI
1954, Q42002, Q l
2.32%
1.77%
1954, H l 2001, H2
1.99%
1.38%
1969, Q42002, Q l
1.62%
1.22%
1982, Q 3 2002, Q l
1.29%
0.97%
1.10%
0.91%
1.29%
0.97%
Panel A: maximal sample

Sample
RMSE
MAE
Nov. 1974May 2002

1.65%
1.17%
Panel B: common time period (September 1982-March 2002)

RMSE
MAE
1.07%
0.85%
1.24%
0.95%
1.28%
0.97%

least 10%. These long tails are a feature throughout our sample and are not
a particular reflection of present circumstances. Our judgment (following
Curtin, 1996) is that these extreme observations are not particularly
informative, and so we focus on the median and interquartile range as the
relevant indicators of central tendency and disagreement, respectively.
The extent of disagreement within each of these surveys varies dramatically over time. Figure 3 shows the interquartile range over time for each
of our inflation expectations series. A particularly interesting feature of
these data is that disagreement among professional forecasters rises and
falls with disagreement among economists and the general public. Table 3
confirms that all of our series show substantial co-movement. This table
focuses on quarterly databy averaging the monthly Michigan numbers
and linearly interpolating the semiannual Livingston numbers. Panel A
shows correlation coefficients among these quarterly estimates. Panel
B shows correlation coefficients across a smoothed version of the data (a
five-quarter centered moving average of the interquartile range). (The
experimental Michigan data show a somewhat weaker correlation, particularly in the high-frequency data, probably reflecting measurement
error caused by the fact that these estimates rely heavily on the proportion
of the sample expecting price declinesa small and imprecisely estimated fraction of the population.)
Figure 2 DISTRIBUTION OF INFLATION EXPECTATIONS
Professional Economists
Consumers
Livingston Survey and SPF, Combined
Michigan Survey
Empirical Distribution
Empirical Distribution
Kernel Density Estimate
10-
Kernel Density Estimate
10-
0- 1 0
1
2
3
4
Expected Inflation over the Year to December 2003, %
-5.0
-2.5
0.0
2.5
5.0
7.5
10.0
Expected Inflation over the Year to December 2003, %
Expectations < -5% and > 10% truncated lo endpoints.

Figure 3 DISAGREEMENT OVER INFLATION EXPECTATIONS THROUGH
TIME
Disagreement Among Consumers

10-
f 4H
a
Michigan Experimental Series
Michigan Survey
2H
1950
1960
1970
1980
1990
2000
Year
2.5H
Disagreement Among Economists
S)2.0*15H
1.0^0
o.oH
1950
Survey of Professional Forecasters

1960
1970
1980
Livingston Survey
1990
2000
1990
2000
Year
Inflation Rate
2
5i
o1950
1960
1970
1980
Year
Date reflects when the forecast is made.

Table 3 DISAGREEMENT THROUGH TIME: CORRELATION ACROSS
SURVEYS1
Michigan
experimental
Livingston
0.682
0.809
1.000
0.391
1.000
0.700
0.667
0.502
0.231
0.712
0.702
Michigan
SPF-GDP
deflator
SPF-CPI
1.000
0.688
1.000
1.000
0.865
1.000
Panel A: actual quarterly data
Michigan
Michigan
experimental
Livingston
SPF-GDP
deflator
SPF-CPI
1.000
Panel B: 5 quarter centered moving averages
Michigan
Michigan
experimental
Livingston
SPF-GDP
deflator
SPF-CPI
1.000
0.729
0.869
1.000
0.813
1.000
0.850
0.868
0.690
0.308
0.889
0.886
1. Underlying data are quarterly. They are created by taking averages of monthly Michigan data and by linearly interpolating half-yearly Livingston data.
A final source of data on disagreement comes from the range of forecasts within the Federal Open Market Committee (FOMC), as published
biannually since 1979 in the Humphrey-Hawkins testimony.3 Individuallevel data are not released, so we simply look to describe the broad pattern of disagreement among these experts. Figure 4 shows a rough (and
statistically significant) correspondence between disagreement among
policymakers and disagreement among professional economists. The correlation of the range of FOMC forecasts with the interquartile range of the
Livingston population is 0.34, 0.54 or 0.63, depending on which of the
three available FOMC forecasts we use. While disagreement among Fedwatchers rose during the Volcker disinflation, the range of inflation forecasts within the Fed remained largely constantthe correlation between
disagreement among FOMC members and disagreement among professional forecasters is substantially higher after 1982.
We believe that we have now established three important patterns in the
data. First, there is substantial disagreement within both naive and expert
3. We are grateful to Simon Gilchrist for suggesting this analysis to us. Data were drawn
from Gavin (2003) and updated using recent testimony published at http://www.federalreserve.gov/boarddocs/ hh/ (accessed December 2003).
populations about the expected future path of inflation. Second, there are
larger levels of disagreement among consumers than exists among experts.
And third, even though professional forecasters, economists, and the general population show different degrees of disagreement, this disagreement
tends to exhibit similar time-series patterns, albeit of a different amplitude.
One would therefore expect to find that the underlying causes behind this
disagreement are similar across all three datasets.
3. The Central Tendency of Inflation Expectations

Most studies analyzing inflation expectations data have explored whether
empirical estimates are consistent with rational expectations. The rational
expectations hypothesis has strong implications for the time series of
Figure 4 DISAGREEMENT AMONG THE FOMC
Disagreement Through Time
5-Month Ahead Forecasts

3-
91
NM)O
so
96 Correlation (Whole Sample) = 0.54

Correlation (Post-1982) = 0.64
1980 1985 1990 1995 2000

Humphrey Hawkins Testimony Date
1
2
3
IQR of Livingston Forecasts (%)
83
' *}
'3-
88A84
A 93
2u
M M 84 80
194 B85
MB87
BS1
82
2
u
A9A82
80
A 0190
AA900
A 95
A96
A 97
Correlation (Whole Sample) = 0.34
17)1
mm
60
Correlation (Whole Sample) = 0.63

jjo0
o0
1
2
Humphrey-Hawkins testimony in February and July provides forecasts for inflation over the calendar year.
Inflation concept varies.

expectations data, most of which can be stated in terms of forecast efficiency.
More specifically, rational expectations imply (statistically) efficient forecasting, and efficient forecasts do not yield predictable errors. We now
turn to reviewing the tests of rationality commonly found in the literature
and to providing complementary evidence based on the estimates of
median inflation expectations in our sample.4
The simplest test of efficiency is a test for bias: are inflation expectations
centered on the right value? Panel A of Table 4 reports these results,
regressing expectation errors on a constant. Median forecasts have tended
to underpredict inflation in two of the four data series, and this divergence
is statistically significant; that said, the magnitude of this bias is small.5
By regressing the forecast error on a constant and the median inflation
expectation,6 panel B of the table tests whether there is information in
these inflation forecasts themselves that can be used to predict forecasting
errors. Under the null of rationality, these regressions should have no predictive power. Both the Michigan and Livingston series can reject a
rationality null on this score, while the other two series are consistent with
this (rather modest) requirement of rationality.
Panel C exploits a time-series implication of rationality, asking whether
today's errors can be forecasted based on yesterday's errors. In these tests, we
regress this year's forecast error on the realized error over the previous year.
Evidence of autocorrelation suggests that there is information in last year's
forecast errors that is not being exploited in generating this year's forecast,
violating the rationality null hypothesis. We find robust evidence of autocorrelated forecast errors in all surveys. When interpreting these coefficients,
note that they reflect the extent to which errors made a year ago persist in
today's forecast. We find that, on average, about half of the error remains in
the median forecast. One might object that last year's forecast error may not
yet be fully revealed by the time this year's forecast is made because inflation
data are published with only one month lag. Experimenting with slightly
longer lags does not change these results significantly.7
Finally, panel D asks whether inflation expectations take sufficient
account of publicly available information. We regress forecast errors on
recent macroeconomic data. Specifically, we analyze the inflation rate, the
Treasury-bill rate, and the unemployment rate measured one month prior
4. Thomas (1999) provides a survey of this literature.
5. Note that the construction of the Michigan experimental data makes the finding of bias
unlikely for that series.
6. Some readers may be more used to seeing regressions of the form n = a + bEt_12Kt, where
the test for rationality is a joint test of a = 0 and b = 1. To see that our tests are equivalent,
simply rewrite nt - Et_l2n, = a + (1 - b)E,_unt. A test of a = 0 and b = 1 translates into a test
that the constant and slope coefficient in this equation are both zero.
7. Repeating this analysis with mean rather than median expectations yields weaker results.

Table 4 TESTS OF FORECAST RATIONALITY: MEDIAN INFLATION
EXPECTATIONS1
Michigan
Panel A: testing for bias: nt-Et_12nt
a: mean error
(Constant only)
Michiganexperimental
Livingston
SPF (GDP
deflator)
-0.09%
(0.34)
0.63%**
(0.30)
-0.02%
(0.29)
=a
0.42%
(0.29)
Panel B: Is information in the forecast fully exploited? nt - f_12 nt = a + P i

P: ,_12 [nt]
a: constant
Adj. R2
Reject eff.? a = p = 0
(p-value)
0.349**
(.161)
-1.016%*
(.534)
0.197
Yes
(p = 0.088)
-0.060
(.207)
-0.182%
(.721)
-0.003
No
(p = 0.956)
0.011
(.142)
0.595%
(.371)
-0.011
Yes
(p = 0.028)
Panel C: Are forecasting errors persistent? nt - Et_u nt - a

P: nt_u - E t _ 24 [rc,_12]
a: constant
Adj. R2
0.371**
(0.158)
0.096%
(0.183)
0.164
a: constant
-0.816%
(0.975)
0.801***
P : Ef-12 [nt]
(0.257)
y: inflation(_13
-0.218*
(0.121)
K: Treasury billt_13
-0.165**
(0.085)
8: u n e m p l o y m e n t ^ 0.017
(0.126)
Reject eff.? y = K = 8 = 0 Yes
(p-value)
(p = 0.049)
Adjusted R2
0.293
Sample
Periodicity
N
Nov. 1974May 2002

Monthly
290
+ P (7if_12 - Et_24'i^-12)
.580***
(0.115)
0.005%
(0.239)
0.334
Panel D: Are macroeconomic data fully exploited? nt
0.026
(.128)
-0.132%
(.530)
-0.007
No
(p = 0.969)
0.490***
(0.132)
0.302%
(0.210)
0.231
-
Et_12%t
0.640***
(0.224)
-0.032%
(0.223)
0.375
= a
P (_12 [7tJ
0.242%
(1.143)
-0.554***
(0.165)
0.610***
(0.106)
-0.024
(0.102)
-0.063
(0.156)
Yes
(p = 0.000)
0.382
4.424%***
(0.985)
0.295
(0.283)
0.205
(0.145)
-0.319***
(0.106)
-0.675***
(0.175)
Yes
(p = 0.000)
0.306
3.566%***
(0.970)
0.287
(0.308)
0.200
(0.190)
-0.321***
(0.079)
-0.593***
(0.150)
Yes
(p = 0.000)
0.407
1954, Q 4 2002, Q l
Quarterly
169
1954, H l 2001, H2
Semiannual
96
1969, Q42002, Ql
Quarterly
125
1. ***, ** and * denote statistical significance at the 1%, 5%, and 10% levels, respectively (Newey-West standard errors in parentheses; correcting for autocorrelation up to one year).

to the forecast because these data are likely to be the most recent published data when forecasts were made. We also control for the forecast
itself, thereby nesting the specification in panel B of Table 4. One might
object that using real-time data would better reflect the information available when forecasts were made; we chose these three indicators precisely
because they are subject to only minor revisions. Across the three different pieces of macroeconomic information and all four surveys, we often
find statistical evidence that agents are not fully incorporating this information in their inflation expectations. Simple bivariate regressions (not
shown) yield a qualitatively similar pattern of responses. The advantage
of the multivariate regression is that we can perform an F-test of the joint
significance of the lagged inflation, interest rates, and unemployment
rates in predicting forecast errors. In each case the macroeconomic data
are overwhelmingly jointly statistically significant, suggesting that
median inflation expectations do not adequately account for recent available information. Note that these findings do not depend on whether we
condition on the forecast of inflation.
Ball and Croushore (2003) interpret the estimated coefficients in a
regression similar to that in panel D as capturing the extent to which
agents under- or overreact to information. For instance, under the implicit
assumption that, in the data, high inflation this period will tend to be followed by high inflation in the next period, the finding that the coefficient
on inflation in panel D is positive implies that agents have underreacted
to the recent inflation news. Our data support this conclusion in three of
the four regressions (the Michigan series is the exception). Similarly, a
high nominal interest rate today could signal lower inflation tomorrow
because it indicates contractionary monetary policy by the Central Bank.
We find that forecasts appear to underreact to short-term interest rates in
all four regressionshigh interest rates lead forecasters to make negative
forecast errors or to predict future inflation that is too high. Finally, if in
the economy a period of higher unemployment is usually followed by
lower inflation (as found in estimates of the Phillips curve), then a negative coefficient on unemployment in panel D would indicate that agents
are overestimating inflation following a rise in unemployment and thus
are underreacting to the news in higher unemployment. We find that
inflation expectations of economists are indeed too high during periods of
high unemployment, again suggesting a pattern of underreaction; this is
an error not shared by consumers. Our results are in line with Ball and
Croushore's (2003) finding that agents seem to underreact to information
when forming their expectations of inflation.
In sum, Table 4 suggests that each of these data series alternatively
meets and fails some of the implications of rationality. Our sense is that
these results probably capture the general flavor of the existing empirical
literature, if not the somewhat stronger arguments made by individual
authors. Bias exists but is typically small. Forecasts are typically inefficient, though not in all surveys: while the forecast errors of economists are
not predictable based merely on their forecasts, those of consumers are.
All four data series show substantial evidence that forecast errors made a
year ago continue to repeat themselves, and that recent macroeconomic
data is not adequately reflected in inflation expectations.
We now turn to analyzing whether the data are consistent with adaptive expectations, probably the most popular alternative to rational expectations in the literature. The simplest backward-looking rule invokes the
prediction that expected inflation over the next year will be equal to inflation over the past year. Ball (2000) suggests a stronger version, whereby
agents form statistically optimal univariate inflation forecasts. The test in
Table 5 is a little less structured, simply regressing median inflation expectations against the last eight nonoverlapping, three-month-ended inflation observations. We add the unemployment rate and short-term interest
rates to this regression, finding that these macroeconomic aggregates also
help predict inflation expectations. In particular, it is clear that when the
unemployment rate rises over the quarter, inflation expectations fall further than adaptive expectations might suggest. This suggests that consumers employ a more sophisticated model of the economy than assumed
in the simple adaptive expectations model.
Consequently we are left with a somewhat negative resultobserved
inflation expectations are consistent with neither the sophistication of
rational expectations nor the naivete of adaptive expectations. This finding holds for our four datasets, and it offers a reasonable interpretation of
the prior literature on inflation expectations. The common thread to these
results is that inflation expectations reflect partial and incomplete updating in response to macroeconomic news. We shall argue in Section 5 that
these results are consistent with models in which expectations are not
updated at every instant, but rather in which updating occurs in a staggered fashion. A key implication is that disagreement will vary with
macroeconomic conditions.
4. Dispersion in Survey Measures of Inflation Expectations

Few papers have explored the features of the cross-sectional variation in
inflation expectations. Bryan and Venkatu (2001) examine a survey of
inflation expectations in Ohio from 1998-2001, finding that women, singles, nonwhites, high school dropouts, and lower income groups tend to
have higher inflation expectations than other demographic groups. They
00 LO
LO CN CO
T-H
ON IN
LO T1
ON ON
CO
o o
dodo
cr
o oo
co -^
U
w
ft
X
w
o
LO
J
LO CN LO LO
LT) ON LO 00
t N T-H O 1<
d d r-t d
I
'
'
* ^
_LO
CO 00 O
ON
^ LO o ^
rH O i-J O
f^ f~î fî
rn
a;
.. >5
CN
fî
ft
LO LO
CO 00
o
d d
00 LO
CO 00 LO
CN
LO
CO CN CN CN
LO CO LO CN
O T< O i;
,H
0 dd d
LO
31
a-
ft*
>
a
jS
-a
c
u
w
*
*
CO
o
o
d
ft
X
*
*
CO
CO
LO
00 CO
CN LO CN
T1
o.d d
.94
I
* LfT
ON
*
o
11
o p TON-H
d
d d II
1
"' -
LO 00
CO CO
w
w
>
^H
(^
ft
CN
CN
ON
CN
H
ft
tin
In 3
OH
en
H
o
B
LO
CO
X,
w
o
CO
OH
H->
ion
<X)
13
note that these differences are too large to be explained by differences in

the consumption basket across groups but present suggestive evidence
that differences in expected inflation reflect differences in the perceptions
of current inflation rates. Vissing-Jorgenson (this volume) also explores
differences in inflation expectations across age groups.
Souleles (2001) finds complementary evidence from the Michigan
Survey that expectations vary by demographic group, a fact that he interprets as evidence of nonrational expectations. Divergent expectations
across groups lead to different expectation errors, which he relates to differential changes in consumption across groups.
A somewhat greater share of the research literature has employed data on
the dispersion in inflation expectations as a rough proxy for inflation uncertainty. These papers have suggested that highly dispersed inflation expectations are positively correlated with the inflation rate and, conditional on
current inflation, are related positively to the recent variance of measured
inflation (Cukierman and Wachtel, 1979), to weakness in the real economy
(Mullineaux, 1980; Makin, 1982), and alternatively to lower interest rates
(Levi and Makin, 1979; Bomberger and Frazer, 1981; and Makin, 1983), and
to higher interest rates (Barnea, Dotan, and Lakonishok, 1979; Brenner and
Landskroner, 1983). These relationships do not appear to be particularly
robust, and in no case is more than one set of expectations data brought to
bear on the question. Our approach is consistent with a more literal interpretation of the second moment of the expectations data: we interpret different inflation expectations as reflecting disagreement in the population;
that is, different forecasts reflect different expectations.
Lambros and Zarnowitz (1987) argue that disagreement and uncertainty are conceptually distinct, and they make an attempt at unlocking
the two empirically. Their data on uncertainty derives from the SPF,
which asks respondents to supplement their point estimates with estimates of the probability that GDP and the implicit price deflator will fall
into various ranges. These two authors find only weak evidence that
uncertainty and disagreement share a common time-series pattern.
Intrapersonal variation in expected inflation (uncertainty) is larger than
interpersonal variation (disagreement), and while there are pronounced
changes through time in disagreement, uncertainty varies little.
The most closely related approach to the macroeconomics of disagreement comes from Carroll (2003b), who analyzes the evolution of the standard deviation of inflation expectations in the Michigan Survey. Carroll
provides an epidemiological model of inflation expectations in which
expert opinion slowly spreads person to person, much as disease spreads
through a population. His formal model yields something close to the
Mankiw and Reis (2002) formulation of the sticky-information model. In
an agent-based simulation, he proxies expert opinion by the average forecast

in the Survey of Professional Forecasters and finds that his agent-based
model tracks the time series of disagreement quite well, although it cannot match the level of disagreement in the population.
We now turn to analyzing the evolution of disagreement in greater
detail. Figure 3 showed the inflation rate and our measures of disagreement. That figure suggested a relatively strong relationship between inflation and disagreement. A clearer sense of this relationship can be seen in
Figure 5. Beyond this simple relationship in levels, an equally apparent
fact from Figure 3 is that, when the inflation rate moves around a lot, dispersion appears to rise. This fact is illustrated in Figure 6.
In all four datasets, large changes in inflation (in either direction) are
correlated with an increase in disagreement. This fanning out of inflation
expectations following a change in inflation is consistent with a process of
staggered adjustment of expectations. Of course, the change in inflation is
(mechanically) related to its level, and we will provide a more careful
attempt at sorting change and level effects below.
Figure 7 maps the evolution of disagreement and the real economy
through time. The charts show our standard measures of disagreement,
Figure 5 INFLATION AND DISAGREEMENT
Consumers: Michigan
Consumers: Michigan Experimental
Int lation
9.0-
6.0-
6.0-
3.0-
3.0-
nge of Expect
o.o-
o.o-5
10
15
-5
Economists: Livingston
3.0-
10
15
Economists :SPF
3.0-
53
80
2.0-
70
73
78
2.0-
74
53
75
75 >yl>^*'^
78 74y
79
79
1.0-
7(P07
8*8fi^^Ma
?73
l
_
5
10
15
-5
Inflation over the Past Year (%)
)^* 1 90
Figure 6 CHANGES IN INFLATION AND DISAGREEMENT

Consumers: Michigan
9-
9-
6-
6-
3-
3-
Economists^-Livingston
3-
73 74
Economists: SPF
3-
a* 2
275 80
1-
-5
Inflation (Year to t) Less Inflation (Year to t-12), %
plus two measures of excess capacity: an output gap constructed as the

difference between the natural logs of actual chain-weighted real output
and trend output (constructed from a Hodrick-Prescott filter). The shaded
regions represent periods of economic expansion and contraction as
marked by the National Bureau of Economic Research (NBER) Business
Cycle Dating Committee.8
The series on disagreement among consumers appears to rise during
recessions, at least through the second half of the sample. A much weaker
relationship is observed through the first half of the sample. Disagreement among economists shows a less obvious relationship with the
state of the real economy.
The final set of data that we examine can be thought of as either a cause
or consequence of disagreement in inflation expectations. We consider the
dispersion in actual price changes across different CPI categories. That is,
just as Bryan and Cecchetti (1994) produce a weighted median CPI by calculating rates of inflation across 36 commodity groups, we construct
a weighted interquartile range of year-ended inflation rates across
8. We have also experimented using the unemployment rate as a measure of real activity and
obtained similar results.

commodity groups. One could consider this a measure of the extent to
which relative prices are changing. We analyze data for the period
December 1967-December 1997 provided by the Cleveland Fed. Figure 8
shows the median inflation rate and the 25th and 75th percentiles of the
distribution of nominal price changes.
Dispersion in commodity-level rates of inflation seems to rise during
periods in which the dispersion in inflation expectations rises. In Figure 9,
we confirm this, graphing this measure of dispersion in rates of price
change against our measures of dispersion in expectations. The two look
to be quite closely related.
Table 6 considers each of the factors discussed above simultaneously,
reporting regressions of the level of disagreement against inflation, the
squared change in inflation, the output gap, and the dispersion in different commodities' actual inflation rates. Across the four table columns, we
tend to find larger coefficients in the regressions focusing on consumer
expectations than in those of economists. This reflects the differences in
the extent of disagreement, and how much it varies over the cycle, across
these populations.
In both bivariate and multivariate regressions, we find the inflation rate
to be an extremely robust predictor of disagreement. The squared change
Figure 7 DISAGREEMENT AND THE REAL ECONOMY
Disagreement Among Consumers
IO.O-
-4
-2
2.0-.4
Michigan (smoothed)
Michigan - Experimental (smoothed)
Output Gap (RHS)

--6
Disagreement Among Economists
2.5-
A.
2-
1.501950
% 4.0-
a.
SPF (smoothed)
1960
1970
1980
Year
Shaded areas denoted NBER-dated recessions
1990
2000
Figure 8 DISTRIBUTION OF INFLATION RATES ACROSS CPI COMPONENTS

Weighted Percentiles, Based on 36 CPI Component Indices
25th Percentile Inflation Rate
75th Percentile Inflation Rate
IQR of Weighted Component-Level Inflation Rates over Past Year
20-
10-
5-
o-
1970
1980
Year
1990
2000
Figure 9 DISPERSION IN INFLATION EXPECTATIONS AND DISPERSION IN

INFLATION RATES ACROSS DIFFERENT CPI COMPONENTS
Consumers: Michigaiv
7? 8%)
82
9-
^ ?TV
81 82
^ A*
73
73
7
71 7^ 9 9
74
9
V ^
>*^
6-
a,
x
Economists: Livingston
Economists: SPF
80
Pi
74
2-
Jr
78
787g ^r
81 8i 7 5 7 * 0 / ^
00
10
15
-5
Weighted IQR of Inflation Across 36 Commodity Groups
10
15

Table 6 DISAGREEMENT AND THE BUSINESS CYCLE: ESTABLISHING
STYLIZED FACTS1
Michigan
Michiganexperimental
Livingston
SPF (GDP
deflator)
I represents a separate regression)

Panel A: bivariate regressions (each cell
Inflation rate
AInflation-squared
Output gap
Relative price
variability
0.441***
(0.028)
18.227***
(2.920)
0.176
(0.237)
0.665***
(0.056)
0.228***
(0.036)
1.259**
(0.616)
-0.047
(0.092)
0.473***
(0.091)
0.083***
(0.016)
2.682***
(0.429)
0.070**
(0.035)
0.117**
(0.046)
0.092***
(0.013)
2.292**
(0.084)
-0.001
(0.029)
0.132
(0.016)
Panel B: regressions controlling for the inflation rate ([each cell represents a separate
regression)
AInflation-squared
Output gap
Relative price
variability
10.401***
(1.622)
0.415***
(0.088)
0.268***
(0.092)
0.814
(0.607)
0.026
(0.086)
0.210
(0.135)
2.051***
(0.483)
-0.062**
(0.027)
0.085**
(0.042)
-0.406
(0.641)
-0.009
(0.013)
0.099***
(0.020)
0.066***
(0.013)
1.663**
(0.737)
0.020
(0.032)
0.095***
(0.015)
-0.305
(0.676)
-0.007
(0.014)
Panel C: multivariate regressions (full sample)
Inflation rate
AInflation-squared
Output gap
0.408***
(0.028)
7.062***
(1.364)
0.293***
(0.066)
0.217***
(0.034)
0.789
(0.598)
0.017
(0.079)
Panel D: multivariate regressions (including inflation dispersion)
Inflation rate
AInflation-squared
Output gap
Relative price
variability
0.328***
(0.034)
5.558***
(1.309)
0.336***
(0.067)
0.237***
(0.079)
0.204***
(0.074)
-0.320
(2.431)
-0.061
(0.117)
0.210
(0.159)
0.044**
(0.018)
1.398
(0.949)
0.013
(0.039)
0.062
(0.038)
0.037***
(0.011)
-0.411
(0.624)
0.006
(0.018)
0.100***
(0.022)
1. *** and ** denote statistical significance at the 1% and 5% levels, respectively (Newey-West standard
errors in parentheses; correcting for autocorrelation up to one year).
in inflation is highly correlated with disagreement in bivariate regressions, and controlling for the inflation rate and other macroeconomic variables only slightly weakens this effect. Adding the relative price
variability term further weakens this effect. Relative price variability is a
consistently strong predictor of disagreement across all specifications.
These results are generally stronger for the actual Michigan data than for
the experimental series, and they are generally stronger for the Livingston
series than for the SPF. We suspect that both facts reflect the relative role
of measurement error. Finally, while the output gap appears to be related
to disagreement in certain series, this finding is not robust either across
data series or to the inclusion of controls.
In sum, our analysis of the disagreement data has estimated that disagreement about the future path of inflation tends to:
Rise with inflation.
Rise when inflation changes sharplyin either direction.
Rise in concert with dispersion in rates of inflation across commodity
groups.
Show no clear relationship with measures of real activity.
Finally, we end this section with a note of caution. None of these findings
necessarily reflect causality and, in any case, we have deliberately been
quite loose in even speaking about the direction of likely causation.
However, we believe that these findings present a useful set of stylized
facts that a theory of macroeconomic dynamics should aim to explain.
5. Theories of Disagreement
Most theories in macroeconomics have no disagreement among agents. It
is assumed that everyone shares the same information and that all are
endowed with the same information-processing technology. Consequently, everyone ends up with the same expectations.
A famous exception is the islands model of Robert Lucas (1973).
Producers are assumed to live in separate islands and to specialize in producing a single good. The relative price for each good differs by islandspecific shocks. At a given point in time, producers can observe the price
only on their given islands and from it, they must infer how much of it is
idiosyncratic to their product and how much reflects the general price level
that is common to all islands. Because agents have different information,
they have different forecasts of prices and hence inflation. Since all will
inevitably make forecast errors, unanticipated monetary policy affects real
output: following a change in the money supply, producers attribute some

of the observed change in the price for their product to changes in relative
rather than general prices and react by changing production.
This model relies on disagreement among agents and predicts dispersion in inflation expectations, as we observe in the data. Nonetheless, the
extent of this disagreement is given exogenously by the parameters of the
model. Although the Lucas model has heterogeneity in inflation expectations, the extent of disagreement is constant and unrelated to any macroeconomic variables. It cannot account for the systematic relationship
between dispersion of expectations and macroeconomic conditions that
we documented in Section 4.
The sticky-information model of Mankiw and Reis (2002) generates disagreement in expectations that is endogenous to the model and correlated
with aggregate variables. In this model, the costs of acquiring and processing information and of reoptimizing lead agents to update their information sets and expectations sporadically. Each period, only a fraction of the
population update themselves on the current state of the economy and
determine their optimal actions, taking into account the likely delay until
they revisit their plans. The rest of the population continues to act according to their pre-existing plans based on old information. This theory generates heterogeneity in expectations because different segments of the
population will have updated their expectations at different points in time.
The evolution of the state of the economy over time will endogenously
determine the extent of this disagreement. This disagreement in turn affects
agents' actions and the resulting equilibrium evolution of the economy.
We conducted the following experiment to assess whether the stickyinformation model can capture the extent of disagreement in the survey
data. To generate rational forecasts from the perspective of different
points in time, we estimated a vector autoregression (VAR) on U.S.
monthly data. The VAR included three variables: monthly inflation
(measured by the CPI), the interest rate on three-month Treasury bills, and
a measure of the output gap obtained by using the Hodrick-Prescott filter
on interpolated quarterly real GDP.9 The estimation period was from
March 1947 to March 2002, and the regressions included 12 lags of each
variable. We take this estimated VAR as an approximation to the model
rational agents use to form their forecasts.
We follow Mankiw and Reis (2002) and assume that in each period, a
fraction \ of the population obtains new information about the state of the
economy and recomputes optimal expectations based on this new information. Each person has the same probability of updating their informa9. Using employment rather than detrended GDP as the measure of real activity leads to
essentially the same results.
tion, regardless of how long it has been since the last update. The VAR is
then used to produce estimates of future annual inflation in the United
States given information at different points in the past. To each of these
forecasts, we attribute a frequency as dictated by the process just
described. This generates at each point in time a full cross-sectional distribution of annual inflation expectations. We use the predictions from
1954 onward, discarding the first few years in the sample when there are
not enough past observations to produce nondegenerate distributions.
We compare the predicted distribution of inflation expectations by the
sticky-information model to the distribution we observe in the survey
data. To do so meaningfully, we need a relatively long sample period. This
leads us to focus on the Livingston and the Michigan experimental series,
which are available for the entire postwar period.
The parameter governing the rate of information updating in the economy, X, is chosen to maximize the correlation between the interquartile
range of inflation expectations in the survey data with that predicted by
the model. For the Livingston Survey, the optimal X is 0.10, implying that
the professional economists surveyed are updating their expectations
about every 10 months, on average. For the Michigan series, the value of
X that maximizes the correlation between predicted and actual dispersion
is 0.08, implying that the general public updates their expectations on
average every 12.5 months. These estimates are in line with those
obtained by Mankiw and Reis (2003), Carroll (2003a), and Khan and Zhu
(2002). These authors employ different identification schemes and estimate that agents update their information sets once a year, on average.
Our estimates are also consistent with the reasonable expectation that
people in the general public update their information less frequently than
professional economists do. It is more surprising that the difference
between the two is so small.
A first test of the model is to see to what extent it can predict the dispersion in expectations over time. Figure 10 plots the evolution of the
interquartile range predicted by the sticky-information model, given the
history of macroeconomic shocks and VAR-type updating, and setting
X = 0.1. The predicted interquartile range matches the key features of the
Livingston data closely, and the two series appear to move closely
together. The correlation between them is 0.66. The model is also successful at matching the absolute level of disagreement. While it overpredicts
dispersion, it does so only by 0.18 percentage points on average.
The sticky-information model also predicts the time-series movement in
disagreement among consumers. The correlation between the predicted
and actual series is 0.80 for the actual Michigan data and 0.40 for the longer
experimental series. As for the level of dispersion, it is 4 percentage points

Figure 10 ACTUAL AND PREDICTED DISPERSION OF INFLATION
EXPECTATIONS
12-
^ ^ ^ " ^ ~ Predicted: Sticky-Information Model
Actual: Michigan
Actual: Michigan Ex
o
wxa
o
9i i
\h
6-
? 3H
\1
v^ v
li Vv
iff"
o1950
I ' ' '
1960
1970
1980
1990
2000
Year
higher on average in the data than predicted by the model. This may be
partially accounted for by some measurement error in the construction of
the Michigan series. More likely, however, it reflects idiosyncratic heterogeneity in the population that is not captured by the model. Individuals in
the public probably differ in their sources of information, in their sophistication in making forecasts, or even in their commitment to truthful reporting in a survey. None of these sources of individual-level variation are
captured by the sticky-information model, but they might cause the high
levels of disagreement observed in the data.10
Section 4 outlined several stylized facts regarding the dispersion of
inflation expectations in the survey data. The interquartile range of
expected inflation was found to rise with inflation and with the squared
change in annual inflation over the last year. The output gap did not seem
to affect significantly the dispersion of inflation expectations. We reestimate the regressions in panels A and C of Table 6, now using as the
10. An interesting illustration of this heterogeneity is provided by Bryan and Ventaku (2001),
who find that men and women in the Michigan Survey have statistically significant different expectations of inflation. Needless to say, the sticky-information model does not
incorporate gender heterogeneity.
Table 7 MODEL-GENERATED DISAGREEMENT AND MACROECONOMIC

CONDITIONS1
Multivariate regression
Bivariate regressions
Dependent Variable: Interquartile range of model-generated inflation expectations
Constant
Inflation rate
AInflation-squared
Output gap
Adjusted R2
N
0.005***
(0.001)
0.127***
(0.028)
3.581***
(0.928)
0.009
(0.051)
0.469
579
0.166***
(0.027)
6.702***
(1.389)
0.018
(0.080)
579
I. *** denotes statistical significance at the 1% level (Newey-West standard errors in parentheses; correcting for autocorrelation up to one year).
dependent variable the dispersion in inflation expectations predicted by the

sticky-information model with a A of 0.1, the value we estimated using the
Livingston series.11 Table 7 presents the results. Comparing Table 7 with
Table 6, we see that the dispersion of inflation expectations predicted by the
sticky-information model has essentially the same properties as the actual
dispersion of expectations we find in the survey data. As is true in survey
data, the dispersion in sticky-information expectations is also higher when
inflation is high, and it is higher when prices have changed sharply. As with
the survey data, the output gap does not have a statistically significant
effect on the model-generated dispersion of inflation expectations.12
We can also see whether the model is successful at predicting the central tendency of expectations, not just dispersion. Figure 11 plots the
median expected inflation, both in the Livingston and Michigan surveys
and as predicted by the sticky-information model with A = 0.1. The
Livingston and predicted series move closely with each other: the correlation is 0.87. The model slightly overpredicts the data between 1955 and
II. Using instead the value of A, that gave the best fit with the Michigan series (0.08) gives
similar results.
12. The sticky-information model can also replicate the stylized fact from Section 5 that more
disagreement comes with larger relative price dispersion. Indeed, in the sticky-information
model, different price-setters choose different prices only insofar as they disagree on their
expectations. This is transparent in Ball, Mankiw, and Reis (2003), where it is shown that relative price variability in the sticky-information model is a weighted sum of the squared
deviations of the price level from the levels expected at all past dates, with earlier expectations receiving smaller weights. In the context of the experiment in this section, including
relative price dispersion as an explanatory variable for the disagreement of inflation expectations would risk confounding consequences of disagreement with its driving forces.

1965, and it underpredicts median expected inflation between 1975 and
1980. On average these two effects cancel out, so that over the whole sample,
the model approximately matches the level of expected inflation (it overpredicts it by 0.3%). The correlation coefficient between the predicted and the
Michigan experimental series is 0.49, and on average the model matches the
level of median inflation expectations, underpredicting it by only 0.5%.
In Section 3, we studied the properties of the median inflation expectations across the different surveys, finding that these data were consistent
with weaker but not stronger tests of rationality. Table 8 is the counterpart
to Table 4, using as the dependent variable the median expected inflation
series generated by the sticky-information model. Again, these results
match the data closely. We cannot reject the hypothesis that expectations
are unbiased and efficient in the weak sense of panels A and B. Recall that,
in the data, we found mixed evidence regarding these tests. Panels C and
D suggest that forecasting errors in the sticky-information expectations
are persistent and do not fully incorporate macroeconomic data, just as
we found to be consistently true in the survey data.
Table 9 offers the counterpart to Table 5, testing whether expectations
can be described as purely adaptive. This hypothesis is strongly
rejectedsticky-information expectations are much more rational than
Figure 11 ACTUAL AND PREDICTED MEDIAN INFLATION EXPECTATIONS
12-
Predicted: Sticky-Information Model
Actual: Michigan
Actual: Livingston
Actual: Michigan Experimental
9-
I 3H
o1950
1960
1980
1970
Year
1990
2000

Table 8 TESTS OF FORECAST RATIONALITY: MEDIAN
INFLATION EXPECTATIONS PREDICTED BY THE STICKYINFORMATION MODEL 1
Panel A: Testing for bias: n, - Et_n nt = a
Mean error
(Constant only)
0.262%
(0.310)
Panel B: Is information in the forecast fully exploited? nt - E,_12 izt = a + p
p: E M 2 [TCJ
0.436*
(0.261)
-1.416%*
(0.822)
0.088
No
p = 0.227
a: constant
Adj. R2
Reject efficiency?
a = (3 = 0
Panel C: Are forecasting errors persistent? nt - Et_12 K, = a + (3 (nt_u - Et_24

0
ICf-12 - Ef-24 ["l-lJ
- 6 0 4 ***
(0.124)
0.107%
(0.211)
0.361
Constant
Adj. R2
Panel D: Are macroeconomic data fully exploited? nt - f_12 nt = a +

E(-12 M
+ 1 Jtf-13 +
a: constant
P: E M 2 [TCJ
7: inflation,
13
K: Treasury t>illf_13
5: unemployment,..^
Reject efficiency?
y=K = 8 = 0
Adjusted R2
h-U + 5 LJt-13
1.567%*
(0.824)
0.398
(0.329)
0.506***
(0.117)
-0.413**
(0.139)
-0.450***
(0.135)
Yes
p = 0.000
0.369
1. ***, **, and * denote statistical significance at the 1%, 5%, and 10% levels, respectively
(Newey-West standard errors in parentheses; correcting for autocorrelation up to one year).
simple, backward-looking adaptive expectations. Again, this finding

matches what we observed in the survey data.
Given how closely the predicted and actual dispersion of expectations
and median expected inflation co-move, it is not surprising to find that
the results in Tables 4, 5, and 6 are closely matched by the model-generated
time series for disagreement in Tables 7,8, and 9. A stronger test in the tradition of moment-matching is to see whether the sticky-information model can
robustly generate the stylized facts we observe in the data. We verify this by
implementing the following exercise. Using the residuals from our estimated
VAR as an empirical distribution, we randomly draw 720 residual vectors
and, using the VAR parameter estimates, use these draws to build hypothetical series for inflation, the output gap, and the Treasury-bill rate. We then
employ the sticky-information model to generate a predicted distribution of
inflation expectations at each date, using the procedure outlined earlier. To
eliminate the influence of initial conditions, we discard the first 10 years of
the simulated series so that we are left with 50 years of simulated data. We
repeat this procedure 500 times, thereby generating 500 alternative 50-year
histories for inflation, the output gap, the Treasury-bill rate, the median
expected inflation, and the interquartile range of inflation expectations predicted by the sticky-information model with A, = 0.1. The regressions in Tables
4, 5, and 6, describing the relationship of disagreement and forecast errors
Table 9 TESTS OF ADAPTIVE EXPECTATIONS: MEDIAN
INFLATION EXPECTATIONS PREDICTED BY THE STICKYINFORMATION MODEL1
Adaptive expectations: Etnt+U - a + p(X) nt + y Ut + K U,_3 + 5 i, + <|) z,_3
Inflation
p(l): sum of 8 coefficients
Unemployment
y: date of forecast
K : 3 months prior
Treasury bill rate
8 : date of forecast
<)): 3 months prior
Reject adaptive expectations?
( Y = K = 8 = (|> = 0 )
Adjusted R2
N
1.182***
(0.100)
-0.561***
(0.087)
0.594***
(0.078)
0.117***
(0.026)
0.160***
(0.027)
Yes
p = 0.000
0.954
579
1. *** denotes statistical significance at the 1% level. (Newey-West standard errors in

parentheses; correcting for autocorrelation up to a year).
with macroeconomic conditions, are then reestimated on each of these 500

possible histories, generating 500 possible estimates for each parameter.
Table 10 reports the mean parameter estimates from each of these 500
histories. Also shown (in parentheses) are the estimates at the 5th and
95th percentile of this distribution of coefficient estimates. We interpret
this range as analogous to a bootstrapped 95% confidence interval (under
the null hypothesis that the sticky-information model accurately
describes expectations). These results suggest that the sticky-information
model robustly generates a positive relationship between the dispersion
of inflation expectations and changes in inflation, as we observe in the
data. Also, as in the data, the level of the output gap appears to be related
only weakly to the dispersion of expectations.
At odds with the facts, the model does not suggest a robust relationship
between the level of inflation and the extent of disagreement. To be sure,
the relationship suggested in Table 6 does occur in some of these alternative histories, but only in a few. In the sticky-information model, agents
disagree in their forecasts of future inflation only to the extent that they
have updated their information sets at different points in the past. Given
our VAR model of inflation, only changes over time in macroeconomic
conditions can generate different inflation expectations by different people. The sticky-information model gives no reason to find a systematic
Table 10 MODEL-GENERATED DISAGREEMENT AND MACROECONOMIC
CONDITIONS1
Multivariate
regression
Bivariate
regressions
(Dependent Variable: Interquartile range of model-generated inflationexpectations)

Constant
Inflation rate
AInflation-squared
Output gap
loint test on macro data
Adjusted R2
N
1.027***
(0.612; 1.508)
-0.009
(-0.078; 0.061)
0.029***
(0.004; 0.058)
-0.019
(-0.137; 0.108)
Reject at 5% level in
98.2% of histories
0.162
588
th
th
-0.010
(-0.089; 0.071)
0.030***
(0.005; 0.059)
-0.023
(-0.163; 0.116)
588
1. *** denotes statistical significance at the 1% level. (The 5 and 95 percentile coefficient estimates across
500 alternative histories are shown in parentheses.) Adjusted R2 refers to the average adjusted R2
obtained in the 500 different regressions.

relationship between the level of inflation and the extent of disagreement.
This does not imply, however, that for a given history of the world such
an association could not exist, and for the constellation of shocks actually
observed over the past 50 years, this was the case, as can be seen in Table 7.
Whether the level of inflation will continue to be related with disagreement is an open question.
Table 11 compares the median of the model-generated inflation expectations series with the artificial series for inflation and the output gap. The
results with this simulated data are remarkably similar to those obtained
earlier. Panel A shows that expectations are unbiased, although there are
many possible histories in which biases (in either direction) of up to onequarter of a percentage point occur. Panel B shows that sticky-information
expectations are typically inefficient, while panel C demonstrates that
they induce persistent forecast errors. Panel D shows that sticky-information expectations also fail to exploit available macroeconomic information
fully, precisely as we found to be true in the survey data on inflation
expectations. The precise relationship between different pieces of macroeconomic data and expectation errors varies significantly across histories,
but in nearly all of them there is a strong relationship. Therefore, while the
coefficients in Table 11 are not individually significant across histories,
within each history a Wald test finds that macroeconomic data are not
being fully exploited 78.6% of the time. That is, the set of macro data that
sticky-information agents are found to underutilize depends on the particular set of shocks in that history.
Table 12 tests whether sticky-information expectations can be confused
for adaptive expectations in the data. The results strongly reject this possibility. Sticky-information expectations are significantly influenced by
macroeconomic variables (in this case, the output gap and the Treasurybill rate), even after controlling for information contained in past rates of
inflation.
The sticky-information model does a fairly good job at accounting for
the dynamics of inflation expectations that we find in survey data. There
is room, however, for improvement. Extensions of the model allowing for
more flexible distributions of information arrival hold the promise of an
even better fit. An explicit microeconomic foundation for decisionmaking
with information-processing costs would likely generate additional sharp
predictions to be tested with these data.
6. A Case Study: The Volcker Disinflation

In August 1979, Paul Volcker was appointed chairman of the Board of
Governors of the Federal Reserve Board, in the midst of an annual inflation

Table 11 TESTS OF FORECAST RATIONALITY: MEDIAN INFLATION
EXPECTATIONS PREDICTED BY THE STICKY-INFORMATION MODEL OVER
SIMULATED HISTORIES1
Panel A: Testing for bias: %t - Et_u %t = a
Mean error
(Constant only)
0.057%
(-0.264; 0.369)
Panel B: Is information in the forecast fully exploited? nt - Et_12 n, = a + P E,_12 nt

(3 : Et 12 [nt]
a : constant
Adjusted R2
Reject efficiency? a = (3 = 0
0.308**
(0.002; 0.6971)
-1.018%
(-2.879; 0.253)
95.4% of histories
Panel C: Are forecasting errors persistent? nt - Et_u 7if = a + (3 (rc M2 - (_24 7iM2)
P:n H2 -E f _ 24 [7t,_ 12 ]
a : constant
Adjusted R2
0.260***
(0.094; 0.396)
0.039%
(-0.237; 0.279)
0.072
Panel D: Are macroeconomic data fully exploited? nt - Et_u nt = a + P Ef_12 [nt]
a : constant
P : Ef-12 [nt]
Y: inflation,_13
K: Treasury billf_13
8 : output g a p w 3
Joint test on macro data (Y = K = 8 = 0)
Adjusted R2
N
-0.617%
(-3.090; 1.085)
0.032
(-0.884; 0.811)
0.064
(-0.178; 0.372)
0.068
(-0.185; 0.385)
0.170
(-0.105; 0.504)
78.6% of histories
0.070
569
1. *** and ** denote statistical significance at the 1% and 5% levels, respectively. (The 5th and 95th percentile
coefficient estimates across 500 alternative histories are shown in parentheses.) Adjusted R2 refers to the
average adjusted R2 obtained in the 500 different regressions.

Table 12 TESTS OF ADAPTIVE EXPECTATIONS: MEDIAN INFLATION
EXPECTATIONS PREDICTED BY THE STICKY-INFORMATION MODEL OVER
SIMULATED HISTORIES1
Adaptive expectations: Et_l2 nt = a + (3 (L) nt + y Ut + K Ut_3 + bit + it_3
Inflation
(3(1): sum of 8 coefficients
Output gap
y: Date of forecast
K : 3 months prior
Treasury bill rate
8 : Date of forecast
: 3 months prior
Reject adaptive expectations?
( Y = K = 8 = <>| = 0)
Adjusted R2
N
1.100**
(0.177; 2.082)
0.380**
(0.064; 0.744)
-0.300
(-0.775; 0.190)
0.063
(-0.042; 0.165)
0.149
(-0.111; 0.371)
Reject at 5% level
in 100% of histories
0.896
569
1. ** denotes statistical significance at the 5% level. (The 5th and 95th percentile coefficient estimates
across 500 alternative histories are shown in parentheses.) Adjusted R2 refers to the average adjusted R2
obtained in the 500 different regressions.
rate of 11%, one of the highest in the postwar United States. Over the next
three years, using contractionary monetary policy, he sharply reduced the
inflation rate to 4%. This sudden change in policy and the resulting shock
to inflation provides an interesting natural experiment for the study of
inflation expectations. The evolution of the distribution of inflation
expectations between 1979 and 1982 in the Michigan Survey is plotted
in Figure 12.13 For each quarter there were on average 2,350 observations in the Michigan Survey, and the frequency distributions are estimated nonparametrically using a normal kernel-smoothing function.
Three features of the evolution of the distribution of inflation expectations stand out from Figure 12. First, expectations adjusted slowly to this
change in regime. The distribution of expectations shifts leftward only
gradually over time in the data. Second, in the process, dispersion
increases and the distribution flattens. Third, during the transition, the
distribution became approximately bimodal.
We now turn to asking whether the sticky-information model can
account for the evolution of the full distribution of expectations observed
in the survey data during this period. Figure 13 plots the distribution of
13. The Livingston and SPF surveys have too few observations at any given point in time to
generate meaningful frequency distributions.
Figure 12 THE VOLCKER DISINFLATION: THE EVOLUTION OF INFLATION

EXPECTATIONS IN THE MICHIGAN SURVEY
Probability Distribution Functions: Consumers' Inflation Expectations
1979, Ql
1979, Q2
1979, Q3
1979, Q4
1980, Ql
1980, Q2
1980, Q3
1980, Q4
1981,Ql
1981, Q2
1981, Q3
1981, Q4
1982, Ql
1982, Q2
1982, Q3
1982, Q4
0.0080.0060.0040.0020.000 -
n of Pop
o
"S
o
o
iH
0.0080.0060.0040.002-
o.ooo0.0080.0060.004 J
0.002-
o.ooo0.0080.0060.0040.002-
o.ooo-5
10
15
20
-5
10
15
20
-5
10
15
20
-5
10
15
20
Expected Inflation Over the Next Year (%)

Figure 13 THE VOLCKER DISINFLATION: THE EVOLUTION OF INFLATION
EXPECTATIONS PREDICTED BY THE STICKY-INFORMATION MODEL
Probability Distribution Functions: Predicted by the Sticky Information Model
1979, Ql
1979, Q2
1979, Q3
1979,
Q4
1980, Ql
1980, Q2
1980, Q3
1980,
Q4
1981, Q2
1981, Q3
1981,
Q4
1982, Q2
1982, Q3
1982,
Q4
0.60.40.2-
o.o0.6-
0.4-
0.2-
Q,
O
o.o-
i^
M
1981,Ql
i-i
oa
o
0.60.40.2-
IH
/I \
o.o-
1982, Ql
12
12
12
Expected Inflation Over the Next Year (%)
12

inflation expectations predicted by the VAR application of the stickyinformation model described in Section 5.
In the sticky-information model, information disseminates slowly
throughout the economy. As the disinflation begins, a subset of agents who
have updated their information sets recently lower their expectation of inflation. As they do so, a mass of the cross-sectional distribution of inflation
expectations shifts leftward. As the disinflation proceeds, a larger fraction of
the population revises its expectation of the level of inflation downward,
and thus a larger mass of the distribution shifts to the left. The distribution
therefore flattens and dispersion increases, as we observed in the actual data.
The sudden change in inflation isolates two separate groups in the population. In one group are those who have recently updated their information sets and are now expecting much lower inflation rates. In the other
are those holding to pre-Volcker expectations, giving rise to a bimodal distribution of inflation expectations. As more agents become informed, a
larger mass of this distribution shifts from around the right peak to
around the left peak. Ultimately, the distribution resumes its normal single peaked shape, now concentrated at the low observed inflation rate.
Clearly the sticky-information model generates predictions that are
too sharp. Even so, it successfully accounts for the broad features of the
evolution of the distribution of inflation expectations during the Volcker
disinflation.
7. Conclusion
Regular attendees of the NBER Macroeconomics Annual conference are well
aware of one fact: people often disagree with one another. Indeed, disagreement about the state of the field and the most promising avenues for research
may be the conference's most reliable feature. Despite the prevalence of disagreement among conference participants, however, disagreement is conspicuously absent in the theories being discussed. In most standard
macroeconomic models, people share a common information set and form
expectations rationally. There is typically little room for people to disagree.
Our goal in this paper is to suggest that disagreement may be a key to
macroeconomic dynamics. We believe we have established three facts
about inflation expectations. First, not everyone has the same expectations.
The amount of disagreement is substantial. Second, the amount of disagreement varies over time together with other economic aggregates.
Third, the sticky-information model, according to which some people form
expectations based on outdated information, seems capable of explaining
many features of the observed evolution of both the central tendency and
the dispersion of inflation expectations over the past 50 years.
We do not mean to suggest that the sticky-information model explored

here is the last word in inflation expectations. The model offers a good
starting point. It is surely better at explaining the survey data than are the
traditional alternatives of adaptive or rational expectations, which give
no room for people to disagree. Nonetheless, the model cannot explain
all features of the data, such as the positive association between the level
of inflation and the extent of disagreement. The broad lesson from this
analysis is clear: if we are to understand fully the dynamics of inflation
expectations, we need to develop better models of information acquisition and processing. About this, we should all be able to agree.
8. Appendix: An Experimental Series for the Mean and Standard

Deviation of Inflation Expectations in the Michigan Survey from
1946 to 2001
The Michigan Survey of Consumer Expectations and Behavior has been
run most quarters since 1946, Ql, and monthly since 1978. The current
survey questions have been asked continuously since January 1978 (see
Curtin, 1996, for details):
Qualitative: "During the next 12 months, do you think that prices in general
will go up, or go down, or stay where they are now?"
Quantitative: "By about what percent do you expect prices to go (up/down) on
the average, during the next 12 months?"
For most of the quarterly surveys from June 1966-December 1976, a

closed-ended version of the quantitative question was instead asked as:
Closed: "How large a price increase do you expect? Of course nobody can know
for sure, but would you say that a year from now prices will be about 1 or 2%
higher, or 5%, or closer to 10% higher than now, or what?"
Prior to 1966, the survey did not probe quantitative expectations at all,
asking only the qualitative question.
Thus, for the full sample period, we have a continuous series of only
qualitative expectations. Even the exact coding of this question has varied
through time (Juster and Comment, 1978):
1948 (Ql)-1952 (Ql): "What do you think will happen to the prices of
the things you buy?"
1951 (Q4), 1952 (Q2)-1961 (Ql): "What do you expect prices of
household items and clothing will do during the next year or sostay
where they are, go up or go down?"

1961 (Q2)-1977 (Q2): "Speaking of prices in general, I mean the prices of the
things you buydo you think they will go up in the next year or go down?"
1977 (Q3)-present: "During the next 12 months, do you think that prices in
general will go up, or go down, or stay where they are now?"
Lacking a better alternative, we proceed by simply assuming that these
different question wordings did not affect survey respondents.
We compile raw data for our experimental series from many different
sources:
1948 (Ql)-1966 (Ql): unpublished tabulations put together by Juster
and Comment (1978, Table 1).
1966 (Q2)-1977 (Q2): tabulations from Table 2 of Juster and Comment (1978).
1967 (Q2), 1977 (Q3)-1977 (Q4): data were extracted from Interuniversity Consortium for Political and Social Research (ICPSR) studies
#3619, #8726, and #8727, respectively.
January 1978-August 2001: a large cumulative file containing microdata
on all monthly surveys. These data were put together for us by the
Survey Research Center at the University of Michigan, although most of
these data are also accessible through the ICPSR.
These raw data are shown in Figure 14.
Figure 14 QUALITATIVE RESPONSES TO THE MICHIGAN SURVEYLONG
HISTORY
i-
Qualitative Price Expectations

Prices will rise
Prices about the same
Prices will fall
.75-
.5-
.25-
o1950
1960
1970
1980
Year
1990
2000
To build a quantitative experimental series from these qualitative data, we

make two assumptions. First, note that a relatively large number of respondents expect no change in prices. We should probably not interpret this literally but rather as revealing that they expect price changes to be small. We
assume that when respondents answer that they expect no change in prices,
they are stating that they expect price changes to be less than some number,
c%. Second, we assume that an individual i's expectation of inflation at time
t, nit, is normally distributed with mean \it and standard deviation at. Note
especially that the mean and standard deviation of inflation expectations are
allowed to shift through time, but that the width of the band around zero for
which inflation expectations are described as unchanged shows no intertemporal variation (that is, there is no time subscript on c).
Consequently, we can express the observed proportions in each category as a function of the cumulative distribution of the standard normal
distribution FN; the parameter c; and the mean and standard deviation of
that month's inflation expectations, [it, and of,
%Downt = F
%Upt = 1 -
Thus, we have two independent data points for each month (%Same is
perfectly collinear with %Up+%Down), and we would like to recover two
time-varying parameters. The above two expressions can be solved simultaneously to yield:
F-l{%Downt) + FN\l-%UVt)
{%Downs)-F-l{l-%Upt)
Gt
= C
Not surprisingly, we can recover the time series of the mean and standard deviation of inflation expectations up to a multiplicative parameter,
c; that is, we can describe the time series of the mean and dispersion of
inflation expectations, but the scale is not directly interpretable. To
recover a more interpretable scaling, we can either make an ad hoc
assumption about the width of the zone from which same responses are
drawn, or fit some other feature of the data. We follow the second approach
and equate the sample mean of the experimental series and the corresponding quantitative estimates of median inflation expectations from the same
survey over the shorter 1978-2001 period when both quantitative and
qualitative data are available. (We denote the median inflation expectation by it.)14 formally, this can be stated:
1978-2001
1978-2001
/_, ^
zL71
which solves to yield:

1978-2001
c=
-i
1
(%
(%Down
t) + F" (%1 - Upt
FNl(%Downt)-F-\%l-UPt)
This assumption yields an estimate of c = 1.7%. That is, the specific scaling adopted yields the intuitively plausible estimate that those expecting
inflation between -1.7% and +1.7% respond that prices will stay where
they are now. More to the point, this specific scaling assumption is not
crucial to any of our regression estimates. It affects the interpretation of
the magnitude of coefficients but not the statistical significance.
Thus, for our sample of T periods, with 2T + 1 parameters and 2T + 1
unknowns, we can estimate the time series of the mean and standard
deviation of inflation expectations. As a final step, we rely on the assumption of normality to convert our estimate of the sample standard deviation
into an estimate of the interquartile range.
Figures 1 and 3 show that the median and interquartile range of the
constructed series move quite closely with the quantitative estimates over
the period from 1978. Table 2 reports on the correlation of this series with
other estimates.
REFERENCES
Ball, Laurence. (2000). Near-rationality and inflation in two monetary regimes.
Cambridge, MA: National Bureau of Economic Research. NBER Working Paper
7988.
Ball, Laurence, and Dean Croushore. (2003). Expectations and the effects of monetary policy. Journal of Money, Credit and Banking 35(4): 473-484.
Ball, Laurence, N. Gregory Mankiw, and Ricardo Reis. (2003). Monetary policy for
inattentive economies, Journal of Monetary Economics, forthcoming.
Barnea Amir, Amihud Dotan, and Josef Lakonishok. (1979). The effect of price
level uncertainty on the determination of nominal interest rates: Some empirical evidence. Southern Economic Journal 46(2): 609-614.
Bomberger, William, and William Frazer. (1981). Interest rates, uncertainty and the
Livingston data. Journal of Finance 36(3): 661-675.
14. It is just as valid to refer to the mean of this experimental series as the median expectation, given the assumption of normality.
Brenner, Menachem, and Yoram Landskroner. (1983). Inflation uncertainties and

returns on bonds. Economica 50(200):463-468.
Bryan, Michael, and Stephen Cecchetti. (1994). Measuring core inflation. In Monetary
Policy, N. Gregory Mankiw (ed.). Chicago: University of Chicago Press for NBER.
Bryan, Michael, and Guhan Venkatu. (2001). The curiously different inflation perspectives of men and women. Federal Reserve Bank of Cleveland Economic
Commentary Series. Available at http://www.clev.frb.org/Research/
Com2001/1015.pdf.
Carroll, Christopher. (2003a). Macroeconomic expectations of households and
professional forecasters. Quarterly Journal of Economics 118(l):269-298.
Carroll, Christopher. (2003b). The epidemiology of macroeconomic expectations.
In The Economy as an Evolving Complex System, III, Larry Blume and Steven
Durlauf (eds.). Oxford, England: Oxford University Press.

Croushore, Dean. (1993). Introducing: The Survey of Professional Forecasters. Federal
Reserve Bank of Philadelphia. Business Review November/December: 3-15.
Croushore, Dean. (1997). The Livingston Survey: Still useful after all these years.
Federal Reserve Bank of Philadelphia. Business Review March/April: 15-27.
Cukierman, Alex, and Paul Wachtel. (1979). Differential inflationary expectations
and the variability of the rate of inflation: Theory and evidence. American
Economic Review 69(4)595-609.
Curtin, Richard. (1996). Procedure to estimate price expectations. University of

Michigan Survey Research Center. Mimeo.
Friedman, Milton. (1968). The role of monetary policy. American Economic Review
Gavin, William T. (2003). FOMC forecasts: Is all the information in the central tendency? Federal Reserve Bank of St Louis. Working Paper 2003-002A.
Juster, F. Thomas, and Robert Comment. (1978). A note on the measurement of
price expectations. Institute for Social Research, University of Michigan.
Unpublished manuscript.
Khan, Hashmat, and Zhenhua Zhu. (2002). Estimates of the sticky-information
Phillips curve for the United States, Canada, and the United Kingdom. Bank of
Canada Working Paper 2002-19.
Levi, Maurice, and John Makin. (1979). Fisher, Phillips, Friedman and the measured impact of inflation on interest. Journal of Finance 34(l):35-52.
Lambros, Louis, and Victor Zarnowitz. (1987). Consensus and uncertainty in economic prediction. Journal of Political Economy 95(3):591-621.
Lucas, Robert E., Jr. (1973). Some international evidence on inflation-output tradeoffs. American Economic Review 63:326-334.
Makin, John. (1982). Anticipated money, inflation uncertainty and real economic
activity. Review of Economics and Statistics 64(1):126-134.
Makin, John. (1983). Real interest, money surprises, anticipated inflation and fiscal deficits. Review of Economics and Statistics 65(3):374-384.
Mankiw, N. Gregory, and Ricardo Reis. (2002). Sticky information versus sticky
prices: A proposal to replace the new Keynesian Phillips curve. Quarterly Journal
of Economics 117(4):1295-1328.
Mankiw, N. Gregory, and Ricardo Reis. (2003). Sticky information: A model of
monetary non-neutrality and structural slumps. In Knowledge, Information and
Expectations in Modern Macroeconomics: In Honor of Edmund S. Phelps, P. Aghion,
R. Frydman, J. Stiglitz, and M. Woodford (eds.). Princeton, NJ: Princeton

University Press.
248 KING
Mullineaux, Donald. (1980). Inflation expectations and money growth in the

United States. American Economic Review 70(l):149-161.
Souleles, Nicholas. (2001). Consumer sentiment: Its rationality and usefulness in
forecasting expenditureEvidence from the Michigan micro data. Journal of
Money, Credit and Banking forthcoming.
Thomas, Lloyd, Jr. (1999). Survey measures of expected U.S. inflation. Journal of
Economic Perspectives 13(4):125-144.
Vissing-Jorgenson, Annette. (2003). Perspectives on behavioral finance: Does

"irrationality" disappear with wealth? Evidence from expectations and actions.
In NBER Macroeconomics Annual 2003, Mark Gertler and Kenneth Rogoff (eds.).
Cambridge, MA: MIT Press.
Comment
ROBERT G. KING*
Boston University, NBER, and Federal Reserve Bank of Richmond
1. Expectations and Macroeconomics

Disagreement about inflation expectations, particularly controversies
over the importance of these expectations for the relationship between
real and nominal variables, has been a central topic in macroeconomics
during the last three decades. Most analyses have taken inflation expectationsand other expectations about macroeconomic variablesas
identical across agents, or they at least have taken the view that crosssectional differences in beliefs are second-order for macroeconomic
phenomena.
The view that average expectations are sufficient for most macroeconomic purposes is present in many diverse lines of research. In the early
studies of Gordon (1970) and Solow (1969), inflation expectations were
viewed as adaptive, but differences across agents in the speed of expectation adjustment were not stressed. Instead, this viewpoint was made
operational by using simple distributed lag specifications as proxies for
expectations, making beliefs about inflation depend only on a subset of
available data despite the fact that it was generally more complicated in
macroeconomic models. Famously criticized by Lucas (1972) and Sargent
(1971), who employed rational expectations models with homogenous
beliefs in their arguments, the adaptive expectations viewpoint has
largely been replaced by rational expectations modeling. Following Lucas
and Sargent, the specific form of rational expectations employed most frequently is that all information is common to agents.
* The views expressed in this comment are not necessarily these of The Federal Reserve Bank
of Richmond or of The Federal Reserve System.
Comment 249
While the homogeneous expectations model has been dominant, it is

important to remember that an earlier line of flexible price macroeconomic research during this period sought to use limited information constructsthe imperfect information models developed by Lucas (1973),
Barro (1976), and others during the late 1970s and early 1980sto rationalize monetary nonneutrality. In contrast to macroeconomic models incorporating rational expectations with common information, these setups
featured incomplete adjustment of average beliefs precisely because individuals had limited and disparate information sets. The profession ultimately turned away from these models, however, for two reasons. First,
their implications were fragile with respect to the specification of the
nature and evolution of information sets. Second, it was difficult to
believe that they explained the apparent nonneutrality of money stock
measures in an economy like that of the United States, with readily available monetary statistics.
1.1 (MY) EXPECTATIONS
Recently, Mankiw and Reis (2002) have resurrected the idea that limited
informationparticularly infrequent adjustment of expectationsis
important for the interplay of real and nominal variables. They do so
within models in which firms are price-setters rather than participants in
competitive markets like those envisioned by Lucas and Barro.
Because I cut my research teeth on the earlier generation of imperfect information models, I was delighted when Mark Gertler asked
me to discuss a prospective paper in which these authors would
explore the evidence for sticky expectations. I thought that it would
be an excellent opportunity to think further about an important
topic: what macroeconomic and microeconomic implications most
sharply distinguish the sticky-expectations model of Mankiw and
Reis (MR) from the popular sticky-price model that has been much
employed in recent macroeconomic research. So I was excited to have
the opportunity.
1.2 EXPECTATIONS ARE NOT ALWAYS FULFILLED
Conference organizers suggest topics to authors and sometimes get
papers that are very different from those expected. Karl Brunner once
asked Robert Lucas to write a survey of empirical evidence on the Phillips
curve and got "Econometric Policy Evaluation: A Critique." My expectations were not fulfilled with this paper, but I am not disappointed. The
Mankiw-Reis-Wolfers (MRW) paper is a fascinating description of various
measures of survey inflation expectations. It documents how these measures
vary through time; how they are related to the level of inflation; how they
250 KING
move over the course of business cycles; and how they evolved during an
important episode, the Volcker deflation. It is sure to stimulate much
interesting future research.
1.3 LINK TO THE STICKY-EXPECTATIONS MODEL
The sticky-expectations model of MR implies that macroeconomic
shocksparticularly monetary policy shockshave real effects because
some agents adjust expectations and others don't. It also has the effect
that monetary shocks cause dispersion in inflation expectations because
some agents adjust their forecasts immediately when a shock occurs and
others do so only gradually. This implication motivates the current paper:
MRW want to find out whether there are important changes over time in
the cross-sectional variability of expectations.
Now, there are other empirical implications of the sticky-expectations
model that one might want to explore, both at the micro and macro levels. In the MR model, when a firm gets an opportunity to update its information, it chooses an entire path for future nominal prices that it will
charge until its next information update.1 To me, this micro implication flies
in the face of one of the central facts that new Keynesian macroeconomics
has long stressed, which is the tendency for many nominal prices to stay
constant for substantial periods of time.2
And there are also macro implications of this adjustment pattern. Ball,
Mankiw, and Romer (1988) use data on a large number of different
countries to argue for sticky-price models rather than the alternative
information-confusion model of Lucas. They argue that sticky-price
models imply that the output-inflation trade-off should depend negatively on the average rate of inflation because high rates of inflation
would induce firms to undertake more frequent adjustments. They
argue that cross-country evidence strongly supports this implication,
rather than Lucas's implication that the slope should depend on variability of inflation. Now, because a Mankiw-Reis firm sets a path of
prices, it can neutralize the effects of the average inflation rate on its
real revenues. Its incentives for frequency of information adjustment
would therefore be unaffected by average inflation, just like Lucas's
flexible price firm, because the MR firm's price is flexible with respect
to forecasted inflation.
2. If a firm chose a nominal price that would be held fixed until the next receipt of information, then the MR model has the attractive characteristic that it simply collapses to the
well-known Calvo (1983) model. Thus, the essential feature of the model is that the firm
chooses a price plan rather than a price.
2. A notable and important exception is the practices of selective discounts, such as sales.
Comment 251
Each of these two implications of the MR model seems inconsistent

with key facts long stressed by Keynesian macroeconomics, old and new.
So if the MR model is the principal motivation for the MRW investigation,
then the link is less than fully satisfactory.
1.4 INTELLECTUAL CURRENTS
There are other reasons for studying disagreement about inflation expectations. Stepping back, the MRW paper is part of recent work that is sometimes called behavioral macroeconomics and at other times called
macroeconomics and individual decisionmaking. This work aims at (1) taking a careful look at how individuals actually make decisions at the individual level, and (2) developing hypotheses about behavior that are
well-specified alternatives to those explored in earlier neoclassical studies of
micro data. Work on behavioral macroeconomics in general and the MRW
paper in particular is thus a timely and welcome contribution. But one must
also bear in mind that survey reports of expectations are not quite the sort of
behavior about which most economistsneoclassical or notare prone to
theorize about. They are not market actions, just statements.
1.5 REMEMBERING MUTH
Even if we take these measures as accurate indicators of individual expectations, it is important to remember Muth's (1961) original description of
rational expectations. He noted that:
"The hypothesis (is) . . . that expectations of firms . . . tend to be
distributed, for the same information set, about the prediction of the
theory . . .."
"The hypothesis asserts three things: (i) that information is scarce and the
economic system generally does not waste it; (ii) the way that
expectations are formed depends specifically on the structure . . . of the
economy; (and) (iii) a 'public prediction' will have no effect... (unless it
is based on inside information)."
"It does not assert that the scratch work of entrepreneurs resembles
the system of equations in any way; nor does it state that the
predictions of entrepreneurs are perfect or that their expectations are
all the same."
So Muth was comfortable with deviations of individual expectations from
average, potentially of a systematic, type. He nevertheless chose to construct an economic model in which only average expectations mattered
and to explore the implications of this model for the dynamics of agricultural prices.
252 KING
1.6 CRITICAL QUESTION
As macroeconomists, we know that there are lots of types of heterogeneity in the world. We abstract from many in building our models, as Muth
did. The key to successful macro model building is to put in heterogeneity that is important for the issue at hand and to leave out the rest. For
example, in studying capital formation, one might think that it is important to take careful account of the age distribution of capital stocks
because this distribution could aid in predicting the timing of firms'
upgrades and replacements. One would like this age distribution of capital stocks to reflect underlying costs, presumably of a fixed sort, that keep
firms from rapidly adjusting their capital stocks.
More specifically, one might thinkas I didthat lumpy investment at the micro level would produce an important set of distributed
lag effects on aggregate investment not present in standard neoclassical models. But the general equilibrium analysis of Thomas (2002)
shows that this need not be the case: one carefully constructed model
with a rich age distribution of capital stocks does not produce very
different investment behavior than the simplest neoclassical model.
So this form of heterogeneity did not turn out to be important in one
particular setting.
By contrast, modern sticky-price models take heterogeneity in nominal
prices, a comparable age distribution of prices, as a first-order phenomenon. Many such models produce very different real responses from those
in flexible price models without a distribution of prices. While most of
these studies impose a time-dependent pattern of price adjustment, the
nonneutrality results of some sticky-price models survive the introduction of state dependent pricing.
So the critical question becomes, Is heterogeneity in beliefs important
for macroeconomic models of the Phillips curve?
2. Expectations, Credibility, and Disinflation

To make the question asked above concrete within a particular model, I
now consider a stylized model of the Volcker deflation, stimulated by
the Mankiw-Reis-Wolfers discussion of this topic in Section 6 of their
paper.
2.1 A STICKY-PRICE MODEL
For this purpose, I use a simple macroeconomic model consisting of an
inflation equation for the private sector and a monetary policy rule that
involves a specification of an inflation path. The examples are simplifications of the analyses of Ball (1994,1995).
Comment 253
2.1.1 Private Behavior The private sector inflation equation is:
where Kt is the inflation rate, Etnt+l is the expectation of future inflation,

yt is a measure of the output gap, and is a slope coefficient that captures
the structural effect that the output gap has on the inflation rate at a given
expected future inflation rate.3 As is well known, this specification
sometimes called the new Keynesian Phillips curvecan be derived from
underlying microeconomic foundations with a stochastic price adjustment mechanism of the Calvo (1983) form.
2.1.2 A Policy of Gradual Disinflation I also assume that the monetary
authority takes whatever monetary actions are necessary to produce a
gradual disinflation path:
nh-gtiort=l,2,...T
n'iov t>T
with g = (nh - nl)/T > 0. This rule specifies that inflation gradually declines
from the high level nhto the low level nl over the course of T periods, with
an identical change in the inflation rate taking place in each period.
2.1.3 Imperfect Credibility and Expected Inflation I finally specify a sense in
which the representative agent sees the policy as imperfectly credible. In
each period, there is a probability at that the disinflation will be continued
next period. If the disinflation is terminated, then inflation will return to
the high level nh and will stay there in all future periods. With this specification, expected future inflation takes the following form:
Etnt
+1
=atnt
1+(l-at)n
Within a successful deflation, the path of the output gap is therefore:
3. A coefficient (3 is sometimes inserted before expected future inflation. Because it is a quarterly discount factor, its value is just below 1 and it is omitted for simplicity in the discussion below.
254 KING
This expression captures two effects familiar from Ball's work on sticky
prices and deflation. First, a perfectly credible (at = 1) deflation produces
a boom in output. Second, if inflation is reduced in an imperfectly credible
manner, then a recession will occur. For example, if the disinflation is
completely incredible (at = 0), then output declines in lock-step with inflation. It also highlights that the behavior of output depends importantly on
the dynamics of beliefs that are here taken to be common across all agents,
i.e., on the behavior of the at over time.
2.2 DYNAMICS OF A SUCCESSFUL DEFLATION
I now use this simple model to analyze an example of dynamics within a
successful disinflation, which is assumed to take three years to complete
and to reduce the inflation rate from 10% per year to 4% per year. In particular, I suppose that the beliefs about the disinflation are initially stubborn, with at = 0 for three quarters, and then gradually rise until the
disinflation is fully credible at its endpoint.
The particular assumptions and their implications for output are displayed in Figure 1. Inflation is assumed to decline gradually, as displayed
in the top panel. The credibility of the disinflation rises through time.
Figure 1 DYNAMICS OF AN IMPERFECTLY CREDIBLE BUT ULTIMATELY
SUCCESSFUL DEFLATION
10
date (in quarters)
Comment 255
Output is initially not much affected but then declines because the disinflation is incredible.4 As its credibility rises, the disinflation's real consequences evaporate.
2.3 REINTERPRETING THE MODEL
To this point, we have assumed that there is no disagreement about inflation expectations in the sense of Mankiw, Reis, and Wolfers. Suppose,
however, that we now assume that there is such disagreement. A fraction
at of the population is optimistic, believing that the disinflation will continue, while the remaining population members are pessimistic. Under
this alternative interpretation, the dynamics of inflation and output are
unaffected, but there would be variability in measures of disagreement
similar to those considered in this paper: disagreement would be small at
the beginning and end of the disinflation, while it would be higher in the
middle. So, in this model, disagreement about inflation expectations can
occur and evolve over time. But modeling these disagreements does not
seem essential to understanding the episode.
2.4 CONNECTING WITH THE ACTUAL DISINFLATION EXPERIENCE
I think that the actual disinflation experience involved the following four
features:
First, it was widely discussed: it is hard to imagine that agents didn't know
that something was up. 5
Second, it was widely debated on two dimensions. People disagreed about
whether it would work and whether it was a good idea. The former
suggests disagreement about expectations.
Third, there was some uncertainty about what was going on: people were
not sure what the Federal Reserve was up to in terms of its long-range
objectives for inflation.
Fourth, it was imperfectly credible. As Shapiro (1994) notes, the Volcker
deflation is very different from the prior disinflation attempts by the
4. As the reader will note, the scale of the output effect depends entirely on the choice of the
parameter <j). In drawing the graph, I chose a = .2, which meant that a maximum output
decline of about 2.5% occurred, although no vertical scale is included in the diagram. A
choice of (|) = .05 would have alternatively brought about a maximum 10% decline in output. In models that derive from underlying micro structure, it is related to two deeper
parameters: the effect of real marginal cost on inflation (which Gali and Gertler [1999] estimate to be about .05) and the elasticity of real marginal cost to the output gap. Dotsey and
King (2001) discuss how some structural features of the underlying economy affect this
latter feature. Values of this elasticity much less than 1 arise from models with elastic labor
supply, variable capacity utilization, and intermediate inputs. Hence, small values of <j)
and large output effects are not hard to generate from modern sticky-price models.
5. This restates a common criticism of the Barro-Lucas-type incomplete information models,
which my then-colleague Stan Engerman once summarized as "Don't the people in your
economies have telephones?" and Ed Prescott later put as "People read newspapers."
256 KING
Federal Reserve. Within a few years after each of the four prior
episodes, inflation was reduced only temporarily and then returned to
an even higher level within a few years.
During the Volcker deflation, long-term interest rates stayed high for a
long time, much longer than any modern pricing modelincluding that
of Mankiw and Reiswould predict, if there was not imperfect credibility about long-term inflation. Unraveling the nature of this episode is an
important topic for research in monetary economics, but I am not convinced that understanding the dynamics of measures of disagreement
about expectations is important for understanding the episode.
2.5 IMPERFECT CREDIBILITY VERSUS STICKY EXPECTATIONS
In terms of practical macroeconomics, one might ask whether I have drawn
a distinction without a difference in my discussion. I don't think so. Sticky
expectations are a structural feature of price dynamics for Mankiw and Reis
and describe both normal situations and unusual events. Imperfect credibility is a feature of the macroeconomy and monetary policy, and is likely
to be more important in some situations than others. So, the inflation-output trade-off during the Volcker deflation might give a poor guide to the
nature of that trade-off in a current monetary policy context.
REFERENCES
Ball, Laurence. (1994). Credible disinflation with staggered price-setting. American
Economic Review 84(1): 282-289.
Ball, Laurence. (1995). Disinflation with imperfect credibility. Journal of Monetary
Economics 35(1): 5-23.
Ball, Laurence, N. Gregory Mankiw, and David Romer. (1988). The new Keynesian
economics and the output-inflation trade-off. Brookings Papers on Economic
Activity 1988(1): 1-82.
Barro, Robert J. (1976). Rational expectations and the role of monetary policy.
Journal of Monetary Economics 2(1): 1-32.
Calvo, Guillermo. (1983). Staggered prices in a utility-maximizing framework.

Journal of Monetary Economics 12(3): 383-398.
Dotsey, Michael, and Robert G. King. (2001). Production, pricing and persistence.
Cambridge, MA: National Bureau of Economic Research. NBER Working Paper
No. 8407.
Gali, Jordi, and Mark Gertler. (1999). Inflation dynamics: A structural econometric
analysis. Journal of Monetary Economics 44(2): 195-222.
Gordon, Robert J. (1970). The recent acceleration of inflation and its lessons for the
future. Brookings Papers on Macroeconomics 1:8-41.
Lucas, Robert E., Jr. (1972). Econometric testing of the natural rate hypothesis. In
The Econometrics of Price Determination, Otto Eckstein (ed.). Washington, DC:
Board of Governors of the Federal Reserve System.

Lucas, Robert E., Jr. (1973). Some international evidence on output inflation tradeoffs. The American Economic Review 63(3): 326-334.
Comment 257
of Economics 117(4): 1295-1328.
Muth, John R (1961). Rational expectations and the theory of price movements.
Econometrica 29(3):315-335.
Sargent, Thomas J. (1971). A note on the accelerationist controversy. Journal of
Money, Credit and Banking 3(August):50-60.
Shapiro, Matthew D. (1994). Federal Reserve policy: Cause and effect. In Monetary
Policy, N. G. Mankiw (ed.). Cambridge, MA: MIT Press.
Solow, Robert M. (1969). Price Expectations and the Behavior of the Price Level.
Mancheser, UK: Manchester University Press.

Thomas, Julia K. (2002). Is lumpy investment relevant for the business cycle?
Journal of Political Economy 110:508-534.
Comment
JOHN C. WILLIAMS
Federal Reserve Bank of San Francisco
This is an excellent paper that uncovers several novel and fascinating

"stylized facts" about cross-sectional dispersion of inflation expectations
based on surveys of households and economists in the United States. Of
particular interest is the finding that the degree of dispersion is positively
correlated with both the inflation rate and dispersion in relative prices. In
addition, the authors propose a theory that can account for many of the
empirical time-series regularities related to both the median and dispersion in surveys of inflation expectations. Given the central role of expectations in modern macroeconomic theory, this paper is certain to stimulate a
wide range of theoretical and empirical research aimed at understanding
heterogeneous expectations and their implications for the behavior of the
economy. A question of immediate interest is whether the stylized facts
regarding inflation expectations in the United States also describe expectations of other key macroeconomic variables, such as gross domestic product (GDP) and interest rates, and expectations data in other countries.
Throughout my discussion I will follow the authors' lead and treat surveys as representing reasonably accurate measures of agents' expectations. But it is worth keeping in mind that expectations derived from
financial market data can differ in important ways from expectations
taken from surveys. For example, as noted in the paper, Ball and
Croushore (2001) document the insensitivity of the median value from
surveys of inflation expectations to economic news. In contrast,
I would like to thank Kirk Moore for excellent research assistance
258 WILLIAMS
Gurkaynak et al. (2003) find that forward nominal interest rates are
highly sensitive to economic news, and they provide evidence that this
sensitivity is primarily related to the inflation component of interest
rates. Because financial market participants "put their money where
there mouths are," one is tempted to put greater faith in estimates taken
from financial market data, even while recognizing the difficult measurement problems associated with extracting expectations from these
data. Still, additional study and comparison of both sources of expectations data is needed to form a more complete picture of the properties of
expectations.
The remainder of my discussion will focus on two topics: learning and
model uncertainty. The first relates to is the real-time information that
forecasters are assumed to possess. The second provides an alternative
explanation of the evidence on dispersion in forecasters' inflation expectations based on the notion that there exists a range of competing forecast
models. I find that model uncertainty provides an intuitively more
appealing description of the form of disagreement among economists
than that proposed in the paper.
The authors argue that the Mankiw and Reis (2002) sticky-information
model can explain many of the properties of the median values and dispersion of surveys of inflation expectations. In this model, agents use a
three-variable, 12-lag monthly vector auto regression (VAR), that includes
inflation, the output gap, and the three-month T-bill rate, estimated over
the entire postwar sample to generate forecasts.1 Individual agents, however, update their expectations only at random intervals, with a 10% probability of an update in each month. Given this structure, the resulting
median sticky-information forecast is closely related to the median of a
geometrically weighted average of past inflation forecasts. The crosssectional dispersion in forecasts reflects the dispersion of forecasts across
vintages. In fact, there is absolutely no disagreement about forecasting
methods; all the differences arise from the differences across vintages of
forecasts that people are assumed to use.
I find the assumption that households and economists had access to
the full-sample VAR estimates to be unrealistic: people in 1960 simply
did not possess the knowledge of forecast model specification and
1. The use of the output gap in the forecasting VAR is problematic because of well-documented problems with real-time estimates of GDP and potential (or the natural rate of)
output, issues emphasized by Orphanides (2001), Orphanides and van Norden (2002),
and others. A preferable approach would be to use the unemployment rate or the realtime estimates of capacity utilization, which is the approach I follow in the model-based
exercises reported in this discussion. As noted by the authors, their results are not sensitive to the use of the output gap in this application, so this criticism is intended more as
a general warning.
Comment 259
Figure 1 IN SAMPLE VERSUS OUT-OF-SAMPLE FORECASTS
18Livingston Survey
VAR (Full-Sample)
VAR (Real-Time)
1614121086420-
1960
1965
1970
1975
1980
1985
1990
1995
2000
Year
parameter estimates that we have accumulated over the subsequent 40 or

more years. Instead, they needed to estimate and test models based on
the limited data that they had on hand and that ran only back to the late
1940s.2 By constructing the sticky-information model forecasts from a
VAR estimated over the full sample, the authors are giving agents far
more information, especially during the earlier part of the sample, than
they had. A more palatable procedure would be to assume that agents
estimate their models in real time, using the vintage of data available to
them, and form forecasts accordingly.
VAR forecasts using the data available at the time track the Livingston
Survey pretty closely through the 1960s and 1970s and do a much better
job at this over that period than forecasts based on a VAR estimated over
the full sample. The shaded gray line in Figure 1 shows the forecasts of
consumer price index (CPI) inflation over the next four quarters from a
real-time, three-variable VAR estimated over data from 1950 through
2. Data from the period of World War II was arguably of limited value for forecasting inflation because of the stringent price controls in place during the war.
260 WILLIAMS
the current quarter.3 The dashed black line reports the corresponding forecasts from a VAR estimated over the full sample. For comparison, the
solid black line shows the Livingston Survey of expected price increases
over the next 12 months.
The forecasts of the real-time and full-sample VARs are nearly identical
from the mid-1980s on, but in the earlier period they display sizable differences. In the 1960s and 1970s, the real-time VAR tracks the Livingston
Survey closely, while the full-sample VAR significantly overpredicts inflation expectations nearly throughout the period. In contrast, in the early
1980s, during the Volcker disinflation, the real-time VAR severely overpredicts inflation expectations. This discrepancy may reflect judgmental
modifications to forecasts that incorporate extra-model knowledge of the
Fed's goals and actions at the time (as well as other influences on inflation) not captured by the simple VAR.
The issue of real-time forecasts versus forecasts after the fact also has
implications for the interpretation of forecast rationality tests reported
in the paper. In describing the properties of median forecasts, the
authors apply standard tests of forecast rationality to the four survey
series that they study. Such tests boil down to looking for correlations
between forecast errors and observable variables, the existence of which
implies that forecast errors are predictable and therefore not rational.
They consider four such tests. The simplest test is that for forecast bias,
i.e., nonzero mean in forecast errors. A second test is for serial correlation in forecast errors in nonoverlapping periods. A third test, which I
call the forecast information test in the following, is a test of correlation
between forecast errors and a constant and the forecast itself. The final
test, which I call the all information test, is a joint test of the correlation
between forecast errors and a set of variables taken from the VAR
described above, assumed to be in forecasters' information set.
They find mixed results on bias and forecast information tests, but
rationality of the median value of surveys is rejected based on the serial
correlation and all information tests. They then show that the median
forecast predicted by the sticky-information model yields similar
resultswith forecast errors exhibiting positive serial correlation and a
high rate of rejection of the forecast information and all information
testsproviding support for that model.
An alternative interpretation of these results is that forecasters have been
learning about quantitative macroeconomic relationships over time. The
3. I chose the CPI for this analysis because it sidesteps the issue of differences between real-time
and final revised data in national income account price indexes, such as the GDP deflator.
The CPI is not revised except for seasonal factors, and because I am focusing on four-quarter
changes in prices, seasonal factors should be of little importance to the analysis.
Comment 261
tests are based on the correlations in the full sample and ignore the fact that
forecasters, even those with the correct VAR model, had inaccurate estimates of these relationships at the time of their forecasts. Because of sampling errors in the forecaster's model, these tests are biased toward rejecting
the null of rationality.4
Indeed, a wide variety of reasonable forecasting models, including a quarterly version of the VAR used in the paper (with the unemployment rate
substituting for the output gap), yield a pattern of rejections similar to those
seen in the survey data when one assumes that the forecasts were constructed in real-time using knowledge of the data correlations available at
the time. Table 1 reports the results from rationality tests from several simple forecasting models. The first line of the table reports the results from the
three-variable VAR with four quarterly lags, where the VAR is reestimated
each period to incorporate the latest observed data point. This real-time VAR
exhibits no bias over the past 40 years, but forecast rationality is rejected
based on positive forecast error serial correlation and the two information
tests. (For this test, I include the most recent observed value of the inflation
rate, the unemployment rate, and the 3-month T-bill rate.) The results for
other forecast models (the details of which I describe below) are also consistent with the evidence from the surveys. And as indicated in the bottom line
of the table, the median forecast among these 10 forecasting models also
exhibits the pattern of rejections seen in the survey data. This evidence suggests that forecasters use models in which the parameters change over time.
I now turn to the second half of the paper. The authors show that the
sticky-information model provides a parsimonious theory of disagreement that is in accord, at least qualitatively, with the time-series pattern of
disagreement seen in the survey data. In addition, the model can generate
a positive correlation between disagreement and the inflation rate, also a
prominent feature of the survey data.
The evidence for the sticky-information model from inflation expectations disagreement from household surveys, however, is not clear cut. The
model cannot come close to matching the magnitude of the dispersion in
household inflation expectations, for which the interquartile range
(IQR)that already excludes one half of the sample as outlierscan
reach 10 percentage points! In Figure 10 of the paper, the difference
between the measure of disagreement in the data and that predicted by
4. In addition to uncertainty about model parameters, the specification of forecasting models changes over time in response to incoming data, driving another wedge between the
information set available to real-time forecasters and after-the-fact calculations of what
forecasters "should have known." In models with time-varying latent variables such as
the natural rates of unemployment and interest, this problem also extends to the real-time
specification and estimation of the latent variable data-generating processes, as discussed
in Orphanides and Williams (2002).
erro
e, th
isth
Ol
low
QJ
IT
u?
.2
:en
stei
en 0)
to X i
en
to
u
QJ
Xj Xi
"*^
T3
tO
"c
u
to
E denotes roo
ata.
asteris ks, between'.
ion
ecast erro:
res
forecast error
sta ndard err<
CN
CN
O
^H
>
5Xi
T3
to
oopooooooo
tO
CJ
01 QJ
-a
c
QJ
to 6 0
QJ 6 0
01 to
g 1O
S K
ean squaj
percent;
onstant a
a consta
_3
to "to
>
in
01
"o
-a o
j>-
oooooooooo
III
I
CN
O
en
'35 In
60
uart
cent
inr<
TH
0)
60
o^
tO
oi O -2 ^
00 Ô ON
CN O O
CN CN CN
-2 o3 -a
6OT3 X!
60 QJ to
<
J i m o Jiifio
Opp
Opp
Opp
ZocsZooZoo
S H CO C T H CO
J J L1 O1O
S " ^
w
CD
<
pa
Sw
OJ
o
T3
O fS
Comment 263
the model is not constant over time and appears to be highly persistent.
There's clearly something else going on here, with the sticky-information
model capturing only part of the process of households' expectations
formation.
The sticky-information model is closely linked to Chris Carroll's (2003)
model, whereby households randomly come into contact with professional forecasts. I find his model to be a highly plausible description of
expectations formation by households, who are unlikely to keep in constant touch with the latest macroeconomic data. But as a macroeconomic
forecaster myself, I find it entirely implausible as a description of the
behavior of business economists and professional forecasters surveyed in
the Livingston Survey and the Survey of Professional Forecasters (SPF),
respectively. Professional forecasters update their forecasts regularly and
update their forecasting models at frequent intervals. The primary reason
economists' forecasts disagree is not due to lags in formulating new forecasts, but instead is because economists themselves disagree about how to
model the economy best!5 This is an aspect of dispersions in expectations
entirely absent from the model in the paper.
In fact, there already exist theories of rational heterogeneity of beliefs
that naturally yield expectations disagreement (see, for example, Brock
and Hommes [1997], Branch [2003], and Branch and Evans [2003]). These
theories assume that agents have at their disposal a range of forecasting
models but are uncertain about which model or models to use. They
update their model choice or priors over the various models based on
forecasting performance. Idiosyncratic differences in agents' characteristics, say, different initial conditions in model priors and the costs for learning new models, implies that a range of models will be in use at any point
in time.
This description matches closely the real-world practice of economic
forecasting that recognizes the high degree of model uncertainty in forecasting. There exists many competing inflation forecast models, including
time-series models, Bayesian VARs, reduced-form Phillips curves, and
large-scale macroeconometric models in use at the same time. And for
each model, several variants differ with respect to model specification and
estimation, including the lag length of explanatory variables; treatment of
latent variables; sample size; and the inclusion or exclusion of additional
explanatory variables such as energy prices, import prices, price control
dummies, sample, wages, productivity, etc. (compare Brayton et al. [1999]
and Stock and Watson [1999]). These models have similarly good track
5. The disagreement seen in published forecasts is an imperfect measure of true disagreement. There are incentives both not stray too far from the consensus (Scharfstein and
Stein, 1990; Lamont, 2002) as well as to stand out from the crowd (Laster et al., 1999).
264 WILLIAMS
records in terms of forecasting performance, but at times they can yield
strikingly different forecasts. In practice, forecasters combine the forecasts
from a subset of these models, along with extra-model information, to
arrive at a point estimate forecast.
But why don't all forecasters arrive at the same forecast? For the same
reason as in the theory sketched above: idiosyncratic differences between
economists imply persistent deviations in modeling choices. One source
of such differences might originate during graduate school training. For
example, economists trained in the 1960s likely rely more heavily on
structural macroeconometric models for forecasting, while those trained
during the 1990s probably place more weight on Bayesian VARs. Because
these models are about equally good in terms of forecasting accuracy, the
pace of convergence to a single best mix of models is likely to be slow.
To illustrate how model uncertainty can lead to forecast disagreement
conforming to the evidence presented in the paper, I construct an artificial
universe of forecasters, each of whom is assumed to use one of the 10 forecasting models listed in Table 1. As seen in the table, these models have
roughly similar out-of-sample forecast accuracy. In each case, the model is
reestimated each period. The parameters are unrestricted. For each of the
three main types of models, I consider three variants: one is estimated by
standard ordinary least squares (OLS) and the second and third are estimated by weighted least squares (WLS), with the weights declining geometrically using the values 0.985 or 0.970, as indicated in the table. WLS
estimation is designed as protection against structural change by downweighting old data (Evans and Honkapohja, 2001). The first main model
is the VAR described above. The second model is a Phillips curve model
that includes a constant, four lags of inflation, and two lags of the unemployment rate. The third model is a fourth-order autoregression. The set
of models is completed with a simple random walk model where the forecast inflation over the next four quarters equals the inflation rate over the
past four quarters.
The out-of-sample forecasting performance (measured by the root
mean squared forecast error) of these various models is quite similar. The
random walk model beats the other models without discounting, consistent with the findings of Atkeson and Ohanion (2001). The VAR model is
the worst performer of the group, supporting Fair's (1979) finding that
unrestricted VAR models tend to perform poorly out of sample. The
Phillips curve model, with discounting, is the best performer of the group,
and in all three cases the model with discounting outperforms the OLS
version. Evidently, structural breaks are of great enough importance in
this sample that protecting against such breaks outweighs the efficiency
loss associated with discarding data (see Orphanides and Williams
Comment 265
[2004]). Finally, the median forecast from this set of 10 models performs
better than any individual forecast, in line with the literature that averaging across forecast models improves performance (see Clement [1989] and
Granger [1989] for surveys of this topic).
At times, these forecasting models yield different forecasts of inflation,
as shown by the shaded region in Figure 2. The degree of disagreement
across models widens appreciably around 1970, again in the mid-1970s,
and most strikingly during the period of the disinflation commencing at
the end of the 1970s and continuing into the early 1980s. The magnitude
of disagreement across models is much smaller during the 1960s and from
the mid-1980s through the end of the sample.
The time-series pattern seen in the interquartile range from these forecast models is similar to that seen in the Livingston Survey IQR, as
depicted in Figure 3. During periods of stable and low inflation, forecast
dispersion among these models is modest, but it spikes when inflation is
high or changing rapidly, exhibiting the same pattern as in the IQR from
the survey data. Of course, the purpose of this exercise is only to illustrate
how model uncertainty can give rise to forecast disagreement similar to
that seen in the survey data. As noted above, the extent of model disagreement extends beyond the set of models I have considered here,
Figure 2 MODEL UNCERTAINTY AND FORECAST DISAGREEMENT
20 -i
Livingston Survey
Range of Model Forecasts
Midpoint of Range
Sticky-Information Model
15-
10-
5-
0-
-5
I960
1965
1970
1975
1980
Year
1985
1990
1995
2000
266 WILLIAMS
suggesting a wider range of disagreement than reported here. On the

other hand, good forecasters will average various models, reducing the
range of disagreement implied by individual models. Careful quantitative
analysis of model-based forecast disagreement is left to future work.
Of course, there are many reasonable alternative explanations, in addition to the sticky-information model, for forecast disagreement among
economists that conform to the main properties of inflation expectations
highlighted in this paper. My goal was to provide an illustrative example
of one such case. (Robert King's discussion of public disagreement
regarding the Federal Reserve's ultimate inflation objective in this volume
provides another.) To test these alternative theories against each other, it
will be useful to examine evidence from expectations of a wider set of
variables, including long-run inflation expectations, and from surveys in
other countries. In addition, this paper has focused on a few moments in
the survey data. The Livingston Survey and SPF are panel datasets that
track the responses through time of individual forecasters. The panel
aspect of this data is an untapped well of information that may help discern different theories of disagreement.
Finally, although expectations disagreement may be useful in discerning alternative models of expectations formation, it is unclear how quantitatively important disagreement on its own, even time-varying
Figure 3 FORECAST DISAGREEMENT
Livingston Survey
Set of Forecasting Models
Sticky-Information Model
1960
1965
1970
1975
1980
Year
1985
1990
1995
2000
Comment 267
disagreement, is for the evolution of the aggregate economy, given a path

for the mean expectation. The macroeconomic implications of timevarying disagreement provide another avenue of future research that is
sure to be stimulated by this fine paper.
REFERENCES
Atkeson, Andrew, and Lee E. Ohanian. (2001). Are Phillips curves useful for forecasting inflation? Federal Reserve Bank of Minneapolis Quarterly Review 25(1): 2-11.
Ball, Laurence, and Dean Croushore (2001). Expectations and the effects of monetary policy. Federal Reserve Bank of Philadelphia. Research Working Paper:
01/12.
Branch, William A. (2003). The theory of rationally heterogeneous expectations:
Evidence from survey data on inflation expectations. Department of Economics,
College of William and Mary. Manuscript.
Branch, William A., and George W. Evans. (2003). Intrinsic heterogeneity in expectation formation. Department of Economics, College of William and Mary.
Manuscript.
Brayton, Flint, John M. Roberts, and John C. Williams. (1999). What's happened to
the Phillips curve? Board of Governors of the Federal Reserve System. Finance
and Economics Discussion Paper Series: 99/49.
Brock, William A., and Cars H. Hommes. (1997). A rational route to randomness.
Econometrica 65(5);1059-1160.
Carroll, Christopher D. (2003). Macroeconomic expectations of households and
professional forecasters. Quarterly Journal of Economics 118(l):269-298.
Clement, Robert T. (1989). Combining forecasts: A review and annotated bibliography. International Journal of Forecasting 5(4):559-583.
Evans, George W, and Seppo Honkapohja. (2001). Learning and Expectations in
Macroeconomics. Princeton, NJ: Princeton University Press.
Fair, Ray C. (1979). An analysis of the accuracy of four macroeconometric models.
Journal of Political Economy 87(4):701-718.
Granger, Clive. (1989) Combining forecastsTwenty years later. Journal of
Forecasting 8:167-174.
Giirkaynak, Refet, Brian Sack, and Eric Swanson. (2003). The excess sensitivity of
long-term interest rates: Evidence and implications for macroeconomic models.
Board of Governors of the Federal Reserve System. Manuscript.
Lamont, Owen A. (2002). Macroeconomic forecasts and microeconomic forecasters. Journal of Economic Behavior and Organization 48(3):265-280.
Laster, David, Paul Bennett, and In Sun Geoum. (1999). Rational bias in macroeconomic forecasts. Quarterly Journal of Economics 114(1):293-318.
of Economics 117(4):1295-1328.
Orphanides, Athanasios. (2001). Monetary policy rules based on real-time data.
American Economic Review 91(4):964-985.
Orphanides, Athanasios, and Simon van Norden. (2002). The unreliability of output-gap estimates in real time. Review of Economics and Statistics 84(4)569-583.
Orphanides, Athanasios, and John C. Williams. (2002). Robust monetary policy
rules with unknown natural rates. Brookings Papers on Economic Activity
2:63-145.
268 WILLIAMS
Orphanides, Athanasios, and John C. Williams. (2004). Imperfect knowledge,
inflation expectations, and monetary policy. In Inflation Targeting, Michael
Woodford, (ed.). Chicago, IL: University of Chicago Press.
Scharfstein, David S., and Jeremy C. Stein. (1990). Herd behavior and investment.
American Economic Review 80(3):465^479.
Stock, James H., and Mark W. Watson. (1999). Forecasting inflation. Journal of
Monetary Economics 44(2):293-335.
Discussion
A number of participants suggested alternative explanations for the disagreement across agents in inflation expectations documented by the
authors, and they recommended that the authors test their theory
against plausible alternatives. Olivier Blanchard suggested the possibility that people form inflation expectations based on small samples of
goods. Inflation variability across goods could then drive dispersion in
expectations. He noted that there is indeed a lot of inflation variability
across goods. He pointed out that this story is consistent with the fact
that there is more dispersion in inflation expectations when inflation is
changing. He also speculated that women might buy different baskets of
goods from men, hence explaining the difference in expected inflation
between women and men in the Michigan Survey. Justin Wolfers
explained that, in favor of Blanchard's story, people's assessment of past
inflation is a good predictor of their inflation expectation. The caveat is
that the extent of variation in the inflation that they think they have
experienced is not rationalizable. Ken Rogoff pointed out that there is
evidence of substantial inflation dispersion across cities within the
United States. He suggested that this might favor the hypotheses of
Blanchard and Williams: that individual forecasts might be made on the
basis of different baskets.
Another explanation was suggested by Mike Woodford. He remarked
that Chris Sims's theory of limited information-processing capacity could
endogenously generate the co-movement of disagreement and other
macro variables. Greg Mankiw responded that the sticky-information
model is a close relation of Chris Sims's work, but that it is analytically
more tractable and generates testable predictions more easily than the
work of Sims.
Ken Rogoff asked whether a story about policy credibility could explain
the fact that there is more disagreement when inflation is changing. He
hypothesized that fat tails in the distribution could be due to expectations
of more extreme histories than the United States has experienced. He
noted that, in view of the historically higher inflation experienced by both
Discussion 269
developing countries and other OECD countries, such expectations were

not necessarily unreasonable. He also remarked that few plays of the
game have been experienced so far. Greg Mankiw objected that a credibility story would not be able to explain positive autocorrelated errors in
forecasts. Robert Shimer responded that Markov switching in inflation
regime and a small sample is sufficient to explain such autocorrelation.
Ricardo Reis agreed with Rogoff that the inflation history of the United
States was uneventful from the point of view of identification.
Athanasios Orphanides was concerned that the authors' sticky-information explanation for disagreement cannot reasonably explain disagreement among professional forecasters who have strong incentives to
update their information regularly. He suggested that a more reasonable
explanation would be disagreement about the model used to forecast
inflation or about estimates of variables such as the natural rate of unemployment. As evidence that such disagreement is widespread, he cited the
response of many forecasters in the SPF that they did not use an estimate
of the NAIRU to forecast inflation. Robert Shimer agreed with
Orphanides that professional forecasters were unlikely to have sticky
information. Justin Wolfers responded to Orphanides that disagreement
about models or the NAIRU is merely a richer version of the stickyinformation explanation of why people stick to bad forecasts for long
periods of time.
Mark Gertler said that examining the source of cyclical dispersion in
expectations is important. He hypothesized that it may be due to something beyond sticky information or imperfect monetary policy credibility.
He noted that, although the Fed is unlikely to suffer from sticky information or imperfect credibility, its Green Book forecasts in the late 1970s
missed both the upsurge in inflation and the disinflation. He remarked
that this forecast error is correlated with dispersion in inflation expectations and suggested that this avenue would be interesting to explore.
Greg Mankiw asked Gertler whether the Green Book forecast errors were
autocorrelated over the period covered by the paper. Gertler responded
that, because inflation was relatively flat over the period, it is hard to distinguish autocorrelation.
The reliability of the data used by the authors concerned some participants. Rick Mishkin contended that household surveys should be
regarded with skepticism. He noted that, in contrast to forecasters, who
make their living from their expectations, households have no incentive
to think hard about their survey responses. He suspected that respondents claiming to expect 10% inflation were unlikely to be behaving in a
way consistent with this expectation, and that the level of dispersion in
the survey responses was exaggerated. Mishkin also noted that there is a
270 DISCUSSION
literature that documented incentives for forecasters to make extreme
predictions to attract attention. Greg Mankiw responded that the fact that
the cyclical response of expected inflation is as predicted by the model,
and that disagreement co-moves strongly across different surveys suggests that they are picking up more than just noise. Mankiw agreed that
the fact that private-sector forecasters are selling a product does affect the
incentives they face compared with, for example, the Fed's Green Book
forecast. Ken Rogoff noted that forecasters may try to avoid changing
their predictions to maintain credibility.
Ricardo Reis stressed that the main point of the paper was to demonstrate the extent of disagreement across agents in inflation expectations.
He remarked that nothing in macro theory so far can explain why there
should be so much disagreement, and the paper explored a first possible
explanation. Reis said that there is a large middle ground between adaptive and hyperrational expectations, and that the paper is an attempt to
explore one possible alternative. Greg Mankiw concluded that the bottom
line of the paper is that disagreement is widespread, and it varies over
time with variables that interest macroeconomists. Hence, macro models
should be consistent with disagreement of this type.

N.G Mankiw, R.reis, J.wolfers Disagreement About Inflation Expectations

Transféré par

Informations du document

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

N.G Mankiw, R.reis, J.wolfers Disagreement About Inflation Expectations

Transféré par

Droits d'auteur :

Formats disponibles

This PDF is a selection from a published volume from

the National Bureau of Economic Research

Volume Title: NBER Macroeconomics Annual 2003,

Title: Disagreement about Inflation Expectations

N. Gregory Mankiw, Ricardo Reis,

Disagreement About Inflation

210 MANKIW, REIS, & WOLFERS

Disagreement About Inflation Expectations 211

Table 1 SURVEYS OF INFLATION EXPECTATIONS

1946, first half

GDP deflator: 1968,

Most quarters from

GDP deflator level,

1. Our quantitative work focuses on the period from 1954 onward.

in industry and professional forecasters, respectively. Table 1 provides

212 MANKIW, REIS, & WOLFERS

SPF: GDP Deflator

Year: Actual and forecast shown at endpoint of horizon

inflation expectations. However, the Michigan Survey of Consumer

Disagreement About Inflation Expectations 213

Panel A: maximal sample

Nov. 1974May 2002

Panel B: common time period (September 1982-March 2002)

214 MANKIW, REIS, & WOLFERS

Livingston Survey and SPF, Combined

Kernel Density Estimate

Kernel Density Estimate

Disagreement About Inflation Expectations 215

Disagreement Among Consumers

Michigan Experimental Series

Disagreement Among Economists

Survey of Professional Forecasters

Date reflects when the forecast is made.

216 MANKIW, REIS, & WOLFERS

Panel A: actual quarterly data

Panel B: 5 quarter centered moving averages

Disagreement About Inflation Expectations 217

3. The Central Tendency of Inflation Expectations

Disagreement Through Time

5-Month Ahead Forecasts

96 Correlation (Whole Sample) = 0.54

1980 1985 1990 1995 2000

10-Month Ahead Forecasts

17-Month Ahead Forecasts

Correlation (Whole Sample) = 0.63

IQR of Livingston Forecasts (%)

218 MANKIW, REIS, & WOLFERS

Disagreement About Inflation Expectations 219

Panel B: Is information in the forecast fully exploited? nt - f_12 nt = a + P i

Panel C: Are forecasting errors persistent? nt - Et_u nt - a

Nov. 1974May 2002

Panel D: Are macroeconomic data fully exploited? nt

220 MANKIW, REIS, & WOLFERS

Disagreement About Inflation Expectations 221

4. Dispersion in Survey Measures of Inflation Expectations

Disagreement About Inflation Expectations 223

note that these differences are too large to be explained by differences in

224 MANKIW, REIS, & WOLFERS

an agent-based simulation, he proxies expert opinion by the average forecast

Consumers: Michigan Experimental

Inflation over the Past Year (%)

Disagreement About Inflation Expectations 225

Figure 6 CHANGES IN INFLATION AND DISAGREEMENT

Consumers: Michigan Experimental